Spiralling bad debts have cast a shadow over the future earnings power of ANZ Banking Group and National Australia Bank (NAB), outweighing the benefits of surging revenue and fatter margins.

Both banks posted interim 2009 falls in net profit and cash earnings on a blowout in non-performing loans.

ANZ’s worse-than-expected cash earnings dived 43 per cent to $954 million.

This was at least $200 million lower than the market expected, prompting Citi to cut forward earnings estimates for ANZ by 10 per cent and recommend selling the stock.

Goldman Sachs JBWere, Bank of America - Merrill Lynch (BoA Merrill), and UBS maintained their recommendations at Hold or Neutral but said the bank’s revision of guidance was disappointing.

ANZ said guidance of flat full year earnings growth would not be met because full year bad debt provisions would rise beyond the $2.5 billion previously flagged.

ANZ’s interim bad debt charge jumped 8.4 per cent to $1.37 billion on the prior corresponding half, while NAB’s increased 2.7 per cent to $1.81 billion.

NAB’s cash earnings fell 9.4 per cent to $2 billion.

Credit Suisse, JPMorgan and UBS maintained a Neutral recommendation on NAB’s stock, while Citi slapped a Sell recommendation on this bank too.

Both banks said there were fewer bad corporate debts at the top end of town and more defaults and problem loans in the small to medium enterprises (SME) sector, a trend likely to continue this year.

ANZ’s heavy exposure to New Zealand saw it charge off more in bad debts for that market than NAB, according to UBS.

But NAB was worse off over bad debts emerging from Australia and the banks’ institutional divisions.

Bad debts are expected to cast a shadow over both banks’ capital positions for at least 18 months.

NAB has underwritten its dividend reinvestment plan (DRP) to raise $500 million of tier 1 capital to support its position.

But ANZ will consider a potential hybrid bond issue to offshore investors in late 2009.

While ANZ declined to comment on any bid for Royal Bank of Scotland’s assets in Asia, regardless of the outcome of any bid process, ANZ will need to raise capital during the second half 2009, Citi said.

Pressure on capital from bad debt provisions has also raised pressure on the banks’ revenue earning power.

First half revenue for both banks surged 11 per cent on the previous corresponding half, as they re-priced corporate and business lending for risk to swell margins and enjoyed strong trading gains from their Markets divisions.

A 66 per cent surge in first half revenue from ANZ’s Markets division made up half of ANZ’s total revenue growth to $7.04 billion courtesy of falling interest rates that led ANZ to flag revenue would be subdued during the current half.

Having widened its overall net interest margin by 26 basis points to 222 basis points to 2007 levels, ANZ’s margin growth should slow as growth in loan volumes weakens, according to Citi.

Margin pressure from both banks’ New Zealand units will be another headwind, BoA - Merrill and JPMorgan said in separate client notes.

For NAB, continuing competition for deposits and weakness in its UK subsidiaries is expected to squeeze margins going forward.

AAP