Westpac's double whammy

This morning's big rise in banking stocks supports Kevin Rudd's decision to reassure Australians about the quality of Australian banks. He could have added that if one unexpectedly gets into strife we have the firepower to safeguard depositors. What prompted the statement was the belief that we were going to see some Australian banks get into deep trouble. All through this crisis I have firmly believed that a global meltdown was unlikely so I don't believe any listed bank in Australia is going to get into deep trouble.

But don't forget that the underlying cause of this chaos remains – what we will see is an extended global credit squeeze which will affect Australian asset values. This problem will not affect our banks solvency but it will affect profits because bad debts will rise. Big parts of NSW are already in recession and that's where the downturn will be felt the most. Banks with large commitments in NSW will be affected.

Westpac shares performed better in the slump than any other major bank reflecting the outstanding work of former chief executive David Morgan. However, I don't think the market understands the longer term NSW-driven vulnerability of Westpac.

At the moment Australia is divided into five relatively well placed states and one that is in a total mess – NSW. The mess in Australia's wealthiest state has been created by an absolutely appalling government over a long period. Ken Phillips of the Institute of Public Affairs has alerted me to the fact that based on past actual figures and current budget estimates the underlying cash deficit for NSW for the three years to June 30 2009 is an astonishing $14.2 billion.

The deficit has risen sharply in each of those three years. In the previous four years NSW's underlying cash position was break even. Very optimistically the NSW Government is punting that its underlying cash deficit in the next three years to 2012 will be reduced from $14.2 billion to $12.4 billion. Yet already we have been warned that NSW's self inflicted downturn looks like blowing out the $6.2 billion underlying cash deficit budgeted for in the current financial year, which means the underlying cash deficit over the three years to 2009 is likely to go through the roof.

This is exactly what happened in Victoria when appalling management of the state in the years leading up to 1990 saw it hit for six by the recession "we had to have”. Anyone with a business relying on Victorian revenue during those tough years went through a very hard time – much worse than most other states. The only way to fix a mess of this sort is to bring in a Kennett/Stockdale type Government, which is a painful experience and in the short term multiplies the misery.

It is unlikely that the current NSW Premier, Nathan Rees will sell assets, slash spending, retrench public servants and/or raise taxes while taking on the NSW Industrial Relations Commission and the vast array of favour-ridden bodies and local governments that are killing the state. The next NSW election is not scheduled until 2011. It will then take at least two years to fix the mess so theoretically NSW may have to wait until 2013 to fully share prosperity with the rest of the country. Three years after the 1987 share crash the Victorian slump in economic activity and asset values created havoc among bankers. NSW is in danger of going through a similar experience.

Westpac is based in NSW and, despite its careful past management, would have received more than its fair share of blows as a result. But Westpac has compounded its NSW problem by buying another NSW-based bank, St George, which may not have had Westpac's lending discipline of the last five years. And, with the benefit of hindsight, Westpac paid too much.

If you speak to most bank analysts they will say there is nothing that they can see that will cause banks to be hit, apart from the well publicised problems of NAB and ANZ. Bank management teams have studied their current loan performance trends and back that view too. But that's exactly what bankers said after the 1987 share crash.

It took just over two years before the balloon went up. Accordingly in the current half year we will see few of these problems emerge. But whenever we have a share market fall of this dimension it is followed by repercussions in the real economy. And those who elect bad governments to drive a state deeper into deficit will see their asset values adjusted down faster and further than well managed areas.