UPDATE 2-Bad debts hit Australia's ANZ, hard times ahead

* H1 cash profit tumbles 43 percent, bad debts soar

* Expects bad debts to worsen in H2 and 2010

* Cuts interim dividend by 26 pct

* Shares fall 5 pct after earnings (Adds CEO, investor comments, background)

By Mette Fraende

SYDNEY, April 29 (Reuters) - Australia's fourth-largest lender, ANZ (ANZ.AX), reported a bigger-than-expected 43 percent drop in half-year cash profit, cut its dividend and forecast tough times ahead as bad debt charges doubled.

The Australia and New Zealand Banking Group also warned investors already rattled by soaring bad debt charges that provisions were likely to worsen in the second half.

"In my bones, I expect further trouble," Chief Executive Mike Smith told reporters, underlining a bearish outlook that knocked ANZ shares down more than 5 percent on Wednesday.

Bad debt charges doubled to A$1.44 billion in the first-half and ANZ said full-year provisions were likely to exceed the A$2.5 billion forecast it made two months ago. Smith said he expected the situation to continue through early 2010.

ANZ's first-half bad debt charges did not rise as fast as those at National Australia Bank (NAB) (NAB.AX), the nation's largest lender, which reported on Tuesday that provisions rose two-and-a-half times to A$1.8 billion. ANZ has a large exposure to Asia, while NAB owns banks in the troubled UK banking sector.

ANZ, as expected, cut its interim dividend by 26 percent, its first reduction since Australia's last recession in the early 1990s. It had warned in February that the full-year dividend will be cut by about a quarter.

Local banks have avoided the banking disasters that have unfolded offshore as they are don't have significant exposure to toxic assets.

But as Australia enters a recession after a lag due to its strong prior growth momentum, banks face slower lending, higher funding costs and growing bad debts as unemployment rises and businesses feel the pinch.

Smith said ANZ had a "rude shock" on mid-size business lending in March. April had not been bad, he added, but he expected worse to come. Second-half provisions were likely to exceed those charged against profits in the first-half, he said.

WORST YET TO COME

Like ANZ, NAB also cut its dividend and warned of a bleaker outlook.

In February, third-ranked Commonwealth Bank of Australia (CBA.AX) reported a 16 percent fall in first-half profit after impairment charges for bad debts in July-December soared almost five-fold to A$1.6 billion.

ANZ said its first-half cash profit -- which excludes one-offs and non-cash accounting items and which forms the basis for dividends -- was A$954 million ($670 million), down from A$1.67 billion a year earlier and well below six analysts' average forecast for A$1.24 billion.

"At a bad debt level they, like NAB, are noting the emerging problems in the small and medium business segment," said Angus Gluskie, managing director at Australian fund manager White Funds Management.

UNDERLYING BUSINESS STRONG

Some bank analysts saw encouraging signs in ANZ's results, noting that underlying profit rose 4 percent from a year earlier, helped by deposit growth and trading income.

"The forecasts by all the banks is that things are likely to deteriorate further, particularly on personal credit," said Paul Xiradis, Chief Executive at fund manager Ausbil Dexia, which has approximately A$7 billion in funds under management.

"But all in all, we are seeing an offset or benefit in the sense that incomes are higher, so it still means they are reporting a reasonably healthy profit overall," he said.

ANZ, together with HSBC Holdings Plc (HSBA.L)(0005.HK) and Standard Chartered Plc (STAN.L), have been reported to be in the running for the Asian assets of Royal Bank of Scotland (RBS.L).

"Obviously, that is certainly in line with our strategy," Smith said, when asked whether ANZ was looking at RBS's Asian assets. Smith said ANZ would consider raising equity if extra capital was needed to help fund an acquisition.

ANZ shares have risen 8.8 percent so far this year, outperforming a 0.4 percent fall in the wider S&P/ASX 200 index .AXJO. ($1=1.424 Australian Dollar) (Additional reporting by Sonali Paul; Editing by Mark Bendeich and Muralikumar Anantharaman)