Saturday, January 29, 2005

Bank values disguised by housing fears (UK)

Times Online

NORTHERN ROCK, the mortgage specialist, opened the bank reporting season on Wednesday with a 13 per cent rise in pre-tax profit and a 14 per cent higher dividend. Its shares promptly fell by 3 per cent. This pattern is likely to be repeated when the bigger banks start revealing their 2004 results in 12 days’ time.

Banks are lower rated than any other successful sector, except housebuilding. HSBC and Standard Chartered, the overseas banks, rate near to the market average. But the seven remaining quoted domestic banks trade at between ten and eleven times their expected 2004 earnings, a bigger discount than usual.

Blame the link with housing. Over three decades, banks regularly lost large sums by lending too much to some cash-hungry region or sector that subsequently collapsed.

There are deep-seated suspicions that a collapse of the UK housing market will be the successor to the great commercial property disaster and the Latin American debt crisis. To say otherwise risks a charge of complacency. Yet the chances of a housing crash big enough to knock clearing bank profits really do look remote.

In the early 1990s, building society profits, in particular, were affected by bad mortgage debts and repossessions. But that was because unemployment doubled to three million in three years. Today, fewer than a million are registered unemployed and the figure has been stable for three years. Falling house prices would, however, inevitably lead to a slowdown in new business, especially if this led, as usual, to a fall in the number of people moving house. First-time buyers are already becoming thinner on the ground.

Goldman Sachs points out, however, that this should lead only to slower growth in mortgage lending, not an actual fall. Goldman Sachs notes that even in 1995, the nadir of the last housing downturn, mortgage lending grew 4 per cent.

The trend in the average new mortgage is determined by house prices over the past seven or ten years, the average life of a mortgage, rather than this year. After a period when prices double, the purchaser of a second-hand house will need a bigger loan than the person who bought it last time.

Even if house prices fall by 20 per cent and transactions fall to a 30-year low, Goldman Sachs calculates that outstanding mortgage loans should still rise by 8 per cent this year and 6 per cent in 2006. If interest rates stabilise this year, profit margins ought to be under less pressure unless lenders stupidly undercut each other to gain market share.

Most banks are about much more than mortgages. Unsecured personal lending, though far less important, may fall back this year. Business lending should pick up to compensate for a slowdown in consumer lending, provided that the banks avoid rushing into modish sectors such as commercial property and management buyouts. Altogether, profits should keep rising, albeit more slowly.

The whole sector offers value, even if bank shares usually perform better towards the end of the year. Investors are spoilt for choice. Royal Bank of Scotland, HBOS and Barclays all look cheap on earnings. Lloyds TSB offers more than 7 per cent dividend yield. At these ratings, more bids from continental banks would make sense too.