Editor’s Note: This article was first published as the January In Focus for CE’s sister letter, Australian Edge.

Europe’s sovereign debt crisis has reached another significant milepost, as late-week news percolated with rumors that Standard & Poor’s was prepared to make another after-Friday’s-close downgrade, this time to major credits on the Continent.

France’s finance minister confirmed that his country’s rating would be downgraded from AAA to AA+ by S&P before the move was made official following the close of trade on the New York Stock Exchange.

German Finance Minister Wolfgang Schaeuble provided essential context for S&P’s latest foray into the news, noting, “In recent months, we have grown to agree worldwide that we shouldn’t overrate the assessments of rating agencies.

“It’s not new that there is a great uncertainty in financial markets regarding the eurozone.” Germany’s credit rating remains AAA, as do those of Luxembourg and The Netherlands, while Austria was also downgraded to AA+.  Italy went from a to BB+, Spain from AA- to A, as S&P hit what are widely seen as the next dominoes in Europe’s debt saga with two-notch downgrades.

The mere event of S&P acknowledging with new letters circumstances known to us for months is not sufficient reason to change our basic focus or unload our dividend-paying stocks generally, unless, of course, there are particular reasons for doing so.

Below we explore the impact on a prominent group of Australia-based stocks, the so-called Big Four banks, including AE Portfolio Conservative Holding Australia & New Zealand Banking Group Ltd (ASX: ANZ, OTC: ANEWF, ADR: ANZBY), pointing out a couple ways to establish positions in solid long-term wealth-builders.

The reality is S&P’s decision to trim France’s sovereign rating could impact the ability of the European Financial Stability Facility (EFSF) to limit interest costs as it raises money to finance deficit spending for governments and therefore achieve the objective of relieving budget pressures on the Continent. The short-run implications are still unknown, though it’s reasonable to conclude the medium- and longer-term impact of greater financial sector stress in a region already slowing down won’t be positive.

The EFSF is reliant upon the good credit of its major AAA funders, including France as well as Germany, Austria, Finland, Luxembourg and The Netherlands, for its own AAA rating, which was granted by the three major ratings agencies–S&P and competitors Fitch Ratings and Moody’s Investor Service–in September 2010.

More than 80 percent of the funding for the rescue vehicle is from Germany (27 percent), France (20 percent), Italy (18 percent), Spain (12 percent) and The Netherlands (6 percent).

Jumping to primary conclusions based on S&P’s work, however, isn’t a road to building wealth over the long term, as the agency continued to vouch for Enron’s solidity right up until its bankruptcy filing. There’s another, more recent analog. So far this long-brewing move–not yet officially announced as of Friday afternoon–hasn’t brought about nearly the same panic stoked in equities markets by the August 2011 downgrade of Uncle Sam.

However, despite the violence of the short-term selloff occasioned by S&P’s downgrade of Uncle Sam, still the most remarkable aspect of the affair is the course of yields on US Treasury obligations in the days, weeks and months afterward. The short story is the US dollar remains the redoubt of choice for frightened investors everywhere, a status proved again by record this week for a USD32 billion auction of three-year notes.

One major difference between what happened in August and what seems to be happening today, a point Mr. Schaeuble makes, is that nobody’s caught off guard.

S&P’s decision to downgrade US credit from AAA came at the conclusion of a long White House vs. Congress, Democrat vs. Republican political battle over what once was a routine legislative act to increase the nation’s borrowing capacity. The game was driven by domestic concerns in the lead-up to a presidential election year, but it was watched, in horror, by market participants around the world.

Even with a nearly year-long prelude S&P’s move on the US was stunning, if only because the “full faith and credit” of the American government has basically been the lynchpin of the global financial system since 1945. Equity markets plunged from near post-Great Financial Crisis highs, as investors sold on fear of spiraling interest costs, fear of a collapsing US dollar, fear of a double-dip.

The yield on the generic US Treasury note actually breached 2 percent to the downside for the first time after Aug. 5, 2011, on its way to a record low of 1.72 percent on Sept. 22. The yield on the current three-year US Treasury note was 0.34 percent late Friday. The yield on the benchmark 10-year Treasury was 1.86 percent as of Friday afternoon.

This latest move on Europe by S&P is not news. That is was leaked midday then released late after the market closed for the week makes it part of a cliché, the “Friday news-dump.” So there may be some fireworks Monday, starting in Asia and Australia. Any panic-driven selloff must, however, be seen as an opportunity to establish positions in high-quality companies.

The Big Four and Wholesale Funding

In late November Westpac Banking Corp (ASX: WBC, NYSE: WBK) CEO Gail Kelly warned of a “contagion effect” sweeping from Europe to Australia to harm it and fellow members of the Big Four. Ms. Kelly’s warning followed an announcement by Commonwealth Bank of Australia Ltd (ASX: CBA, OTC: CBAUF, ADR: CMWAY) that it was delaying issue of a euro-denominated covered bond and suggested to many that a situation much like the Great Financial Crisis was once again at hand, where access to funds for lending would be limited and growth therefore choked off.

In 2008 Australian banks boasted strong capital ratios relative to global peers, low non-performing loans, high credit ratings and spiraling profits. Relations with an active but not intrusive regulator–in fact an overall environment of accommodation, despite restrictions on growth–were the final factor that set Australia’s Big Four apart as some of the safest financial institutions in the world.

But there remained suspicions about their ability to raise funds in Europe; Australia’s Big Four are also more reliant than other globally significant banks on wholesale funding markets, so this was thought to be a particular vulnerability, if one of a very few.

The Big Four and most Australian banks took advantage of government guarantees that allowed them to raised capital during the GFC at AAA rates. Although these loans will mature for some banks beginning in 2012 immediate needs from Europe and international debt markets aren’t as acute as they might have been in 2008. Deposit growth across the Big Four has also been strong, so although reliance on debt funding in international capital markets is still reasonably high it’s not an urgent issue.

The general forecast for the Big Four in fiscal 2011-12 and the immediate beyond is for compressed margins, a result of subdued credit growth exacerbated by higher funding costs.

Westpac’s Kelly recently noted, “As a direct consequence of the turmoil going on in Europe, funding has become a more difficult issue. Right at the moment term markets are effectively closed.”

ANZ CEO Mike Smith, who’s also warned about funding costs, has said that his bank will no longer reflexively follow the Reserve Bank of Australia’s cuts to its overnight interest rate, instead reviewing its rate policy “each fortnight.” Although the RBA has cut its benchmark twice in as many months, “For us,” noted Mr. Smith, “the cost of funding is rising again, if indeed it is available at all.”

The Big Four–ANZ, Westpac, CBA and National Australia Bank Ltd (ASX: NAB, OTC: NAUBF, ADR: NABZY)–are in good position right now, as there’s low credit demand from Australian businesses and consumers, and retail deposit growth rates are extremely healthy at an average of 11 percent, versus 6 percent credit growth. The RBA’s cuts in November and December, which brought its benchmark rate to 4.25 percent, have yet to stimulate new credit demand.

Deposit growth, meanwhile, has been strongest at our favorite of the Big Four, Conservative Holding ANZ, which posted a rate of 13 percent. Loan growth for fiscal 2011 was approximately 7 percent. Westpac, CBA and NAB posted deposit-growth rates of about 10 percent each, while loan growth during fiscal 2011 was 5 percent for Westpac and CBA, 6 percent for NAB.

According to data compiled by Deutsche Bank, the Big Four combined will need approximately AUD90 billion to fund fiscal 2012 operations, down from as much as AUD150 billion in recent years. Of this estimated AUD90 billion, approximately AUD12 billion may be the exposure to European sovereign credit issues. Through a combination of covered bonds, shorter-term money markets and more active participation in private placement deals the Big Four have managed over the past several years to develop alternatives for funding.

ANZ’s wholesale burden is likely to be the lightest, at around AUD17.1 billion, because it’s deliberately slowed mortgage lending growth and has the strongest deposit growth. NAB, meanwhile, could be looking at exposure of AUD26.6 billion that it needs to cover extremely robust mortgage growth. CBA (AUD22.7 billion) and Westpac (AUD21.2 billion) have similar needs. About a quarter of NAB’s funding exposure is to Europe, while Westpac is least open to problems on the Continent, with about 13 percent.

Overall, however, Europe and the UK provide only about a fifth of the overall wholesale funding pie for Australian banks. A third is homegrown, while another 25 percent comes from the US. This diversity will allow Australian banks to avoid the worst of a potential Europe-driven reprise of 2008’s credit crunch, though overseas term markets will remain, again, a small part of the whole. Domestic term issuance is substantially cheaper than international issuance, and short-term funding is still relatively cheap. Stable employment and a relatively healthy economy suggest deposit growth for the group will remain strong, and that deposit spreads will stay reasonable for the medium term.

Rolling over government-guaranteed debt issued during the GFC will provide the first glimpse at this new funding environment for Australia’s banks. About AUD11 billion of this debt will mature during the first quarter of calendar 2012. CBA and NAB paid about 100 basis points more than premiums on senior unsecured debt issued locally in July 2011 when they sold a combined EUR 2.5 billion of the asset-backed notes in early January. Yield premiums on European covered bonds increased to 246 basis points more than government debt as of Jan. 6, from 168 last Jun. 30, according to Bank of America Merrill Lynch data. The price of exchanging the proceeds into Australian dollars reached a record 98.5 basis points last week. The combination of higher swap costs and widening spreads meant CBA and NAB paid about 220 basis points more than the Australian benchmark on their covered notes once the proceeds were exchanged. That compares with the 117 basis-point spread on CBA’s AUD2.5 billion of senior unsecured notes issued on Jul. 22, the most recent benchmark domestic five-year sale by one of Big Four.

CBA’s covered bond was quoted at 96 basis points more than the euro swap rate on Jan. 10, compared with a 139 basis-point spread on its EUR1.5 billion senior unsecured notes due November 2016.

ANZ priced EUR1 billion covered notes due in 2022 at 130 basis points more than the euro mid swap rate on Jan. 9, about 245 basis points over the Australian benchmark. The spread on ANZ’s AUD550 million 6.75 percent senior unsecured notes due May 2016 was recently 154 basis points.

The Australian government has authorized the Big Four to issue up to 8 percent of their net assets in covered bonds, enough to cover maturing government guaranteed funds. It’s clear, however, that funding costs are on the rise, which means banks will have to look to other methods, such as cost-cutting, to meet profit growth objectives. Westpac, for example, has already announced it would shed 1,600 jobs.

All things considered the Big Four should deliver another year of record aggregate profit in fiscal 2012, which is why some Australians and the politicians who serve them are barking about the banks’ refusal to pass on RBA rate cuts automatically. The Big Four are unlikely to win an argument centered on the rational case that official central bank targets are but one factor in the equation that determines costs of capital and so will continue to face pressure at home. They’ll continue to pay more corporate tax in Australia than any other industry. And they’ll likely remain highly profitable, delivering average return on equity double that of their average international peer.

Australian Financials Outperform in 2011

Australia’s Big Four are among only nine banks in the world that have AA ratings. Their quality is recognized far and wide, with all four ranked among the top 25 in Global Finance magazine’s “World’s Safest Banks” for 2011.

Commonwealth Bank of Australia Ltd (ASX: CBA, OTC: CMWAY, CBAUF), the largest with a market cap of AUD79.2 billion, Westpac Banking Corp (ASX: WBC, NYSE: WBK), the second-largest with a AUD63.2 billion market cap, Australia & New Zealand Banking Group Ltd (ASX: ANZ, OTC: ANZBY, ANEWF), No. 3 at AUD56.8 billion, and National Australia Bank Ltd (ASX: NAB, OTC: NABZY, NAUBF), No. 4 at AUD53.3 billion, dominate the Australian banking system but are constrained from asserting any further international influence by an unofficial government policy that prevents them from merging with one another.

There are no impediments to entry into the Australian banking system, but the government does hope to preserve domestic competition by limiting potential scale.

The policy is the subject of continuous debate, as the Big Four themselves argue that this ostensible state sanction also inhibits their ability to compete on a global scale. Other critics charge that the setup allows the four to collude on interest rates and engage in other anticompetitive behavior. From an outsider’s perspective it’s impossible to overlook the fact that Australia’s banks have to date avoided the kind of turmoil that wracked major banks in other developed countries.

And in 2011, when the S&P/ASX 200 Index posted a negative total return in US dollar terms of 9 percent, the S&P/ASX 200 Financials Index was down just 2.26 percent. Global financials, as represented by the S&P Global 1200 Financials Sector Index, shed 19 percent.

Australian financials under AE How They Rate coverage generated a negative average total return of 7.5 percent in US dollar terms. The Big Four, however, were basically flat in US dollar terms in 2011, accounting for dividends as well as market performance.

NAB led the way with a 5.8 percent total return, while CBA posted a 3.5 percent gain. Westpac posted a 3.2 percent loss. Our favorite, ANZ, was worst among the Big Four in US dollar total return terms, with a 6 percent loss.

Since the Sept. 26, 2011, launch of AE NAB is 23.3 percent to the positive, while CBA is up 20.8 percent, all of it share-market and currency gains. Westpac is up 18.4 percent and still lags. But ANZ has jumped to the top of the heap, with a total return of 23.9 percent in US dollar terms since we introduced it and the AE Portfolio.

When we first recommended it we noted that ANZ’s primary competitive advantage is its domestic net funding surplus; we liked that it was relatively insulated from additional operating costs that come with accessing wholesale funding markets. Australian retail and commercial banking is the group’s major operation, but it also runs the largest domestic bank in New Zealand.

New Zealand’s economy, like Australia’s, is resource-focused; Kiwis enjoy extremely low unemployment, too, and growth there is forecast to be among the strongest in the world in 2011. ANZ operates in 25 other countries around the world, including China, Vietnam and Indonesia. The group also provides financial services in the Middle East, Europe and the US. ANZ is full bore into a “no frills” program of dispensing of financial advice, selling “superannuation” and insurance products to retail customers via the telephone. The program has helped the bank boost its deposit funding over the last 12 months.

Fiscal 2011 revenue surged 80 percent, while second-half 2011 net income was AUD2.83 billion versus AUD2.73 billion last year. Those results beat most estimates and came despite a drop in net interest margin to just 2.44 percent. Cash profit, a measure closely watched by analysts, rose by 9.2 percent to AUSD5.61 billion in the year ended Sept. 30. ANZ is on course to post cash earnings of AUD6.11 billion for fiscal 2012, 8.9 percent year-over-year growth.

During the company’s fiscal 2011 conference call CEO Mike Smith called the results “absolutely in line with the key terms and trends” management had previously laid out in an August update. The bank continued to expand its customer franchises in its home markets while expanding aggressively in Asia, China in particular. That’s a strategy it’s followed for the past four years and looks set to stick with despite what Smith called a “much tougher” global environment emerging in the second half of fiscal 2011.

Management throttled back its trading sources to limit risk to the balance sheet, which will reduce growth even as interest rate spreads tighten margins at the traditional business. That leaves Asia as the key area for growth. Revenue from the region is 26 percent of the bank’s institutional revenue, up from 20 percent in 2010. And it’s now 4 percent of group revenue and growing. India revenue rose 115 percent over the past year, China 82 percent and Indonesia 43 percent.

A full-scale collapse of European sovereign debt that took European banks down with it would almost surely hit the stock. The bank’s conservative approach and focus on Asia, however, should keep earnings insulated. Meanwhile, as Mr. Smith stated in the conference call, weakness at other banks is a golden opportunity to gain business and deposits.

There were several pointed questions during the conference call concerning costs, particularly in the context of the bank’s rapid growth. But so far at least the bank is managing profitability well. Moreover, roughly half income is from simple fees, which is growing at a 10 percent annualized rate.

Any selling–such as we saw in early August in the aftermath of S&P’s downgrade of US credit–would be a buying opportunity for this first rate bank. Better international growth prospects than its peers and a similarly solid capital position make ANZ a solid buy up to USD22 on the Australian Securities Exchange.

Westpac’s focused cost-management efforts, peer-leading efficiency ratio and lowest expenses-on-assets ratio recommend it to conservative investors. It’s well positioned with capital and franking credits. And in 2011 it’s reduced its dependence on wholesale funding markets with solid deposit growth.

Westpac posted total revenue for fiscal 2011 of AUD16.91 billion, flat with fiscal 2010. Net income rose 10 percent to AUD6.99 billion, up from AUD6.35 billion. Cash earnings of AUD6.31 billion were 7 percent higher than the previous corresponding period. Westpac declared a final dividend of AUD0.80, fully franked and up from a fully franked AUD0.74 a year earlier.

Looking forward, Westpac CEO Kelly said economic conditions in Europe remained challenging, with sovereign debt concerns leading to activity slowing and the general growth outlook weakening. Commenting during the company’s conference call Ms. Kelly noted, “Associated disruption in financial markets has increased uncertainty and affected global and domestic confidence.” She also pointed out that although Australia is better positioned than most other developed nations, current consumer and business caution is likely to result in subdued credit growth for the medium term. Given the pressures at hand this doesn’t seem too heavy a burden for investors focused on dividend safety and long-term distribution growth. As it is Westpac is well positioned to respond in this environment because of solid operating momentum across all divisions backed by a strong balance sheet.

Westpac reduced its twice-annual payout during the worst of the GFC but is already ahead of its pre-crisis rate, having boosted by 12 percent in fiscal 2011. Currently yielding 7.5 percent, Westpac Banking Corp is a buy up to USD22 on the ASX. Westpac’s New York Stock Exchange-listed American Depositary Receipt, which is worth five ordinary shares, is a buy up to USD110.

Australia’s big four banks have the capacity to cover much of their funding needs by issuing domestic debt, short-term debt and raising deposit money, all of which is cheaper than raising long-term overseas funding, and doesn’t cost any more than it did six months ago. When they have gone overseas borrowing costs have been higher, significantly so. But this burden is relatively light.

This makes their arguments about passing on RBA interest-rate cuts to customers a little untenable; the expectation is that because of these pressures on international markets funding costs must naturally rise, particularly for banks perceived to be more reliant than others for such sources of funding. The Big Four are singing a song in public right now that they hope will allow them to hold onto as much of their net interest margin as they can for as long as possible. They should be able to ride out base-case turbulence, which should reasonably include an approximation but not a repeat of 2008. Based on prior experience you can expect some serious, sovereign-debt-driven selloffs in days ahead. When this happens, pick up ANZ and Westpac.