UK Banks: no longer a mug's game?

I am convinced that UK domestic banks are least understood sector in the market, despite all the media and analyst coverage. The basic reason for this is the huge divergence in forecasts for impairments, NAVs and normalised earnings. As an example, the list below shows the forecasted NAV/share for Lloyds Banking Group (LBG) from various sources.

HSBC: LBG NAV (2011) = 112p
RBS: LBG NAV (2011) = 92p
Redburn: LBG NAV (2011) = 99p
Panmure Gordon: LBG NAV (2011) = 74p
JP Morgan: LBG NAV (2011) = 20-25p

Now this is a most unusual situation. Normally analysts huddle together, unwilling to take a stand too far in one direction. Situations such as this, where this is a huge variance of forecasts make for potentially very attractive investments, assuming you can get your analysis correct. I don’t have the answers yet, but I am finding myself becoming more positive on both the UK domestic banks. There are two main reasons for this:

1) A misunderstanding of the asset protection scheme (APS). The way the APS works is that both LBG and RBS have to take the “first loss” on their asset impairments (£25bn pre tax in the case of LBG), after which the Government takes 90% of any further losses. However not all of the banks’ assets are in the APS. The idea was that only the bad stuff would be put there, in effect creating a pseudo good bank/bad bank structure. A really important question from a valuation perspective is what will happen to the non-APS assets – roughly £460bn in the case of LBG (£260bn are covered by the APS). Many of the bears appear to be assuming continued high level of impairments on the non-APS assets into 2010 and 2011 once the first loss is hit (it is consensus that LBG will hit the first loss in early 2010). However, a contrarian on the sector recently made an excellent point to me: the losses on the non-APS assets are actually likely to be substantially lower than on the APS assets, much lower indeed than most people appear to be assuming. Many of the bears appear to be assuming similar or marginally lower level of losses on the non-APS assets. He reckons the non-APS assets are likely to experience around 25% of the losses experienced by the APS assets. If you run these numbers then the trough valuation looks much more appealing.

2) Economic versus accounting adjustments - NAV / RoE circularities. The other issue with banks, one that becomes much more prevalent during recessions and bear markets, is capital and reserves. During a boom no one cares about book value, but once asset impairments enter the picture suddenly all anyone can think about is whether the bank has enough capital. While this is important from a regulatory perspective, there comes a point where the economic reality becomes obfuscated by accounting gimmicks. For example, some of the bearish analysts are now deducting from capital the APS fee, and doing it up front. Since this is £15.6bn it seriously reduces the capital base. Then they say, “look how high the ROE is! that cannot be sustainable, the bank must need more capital”. The ROE is of course much higher because the capital base has been reduced by 30-40%, but does this actually matter? Is it economic? Imagine if a normal company were to announce that they were paying all their staff 7 years salary up front. Would it make sense to deduct this from their capital? Of course not, it should be amortised over the whole 7 years. Once you realise this you can see that conclusions based on implied ROEs have to be treated with much scepticism.

This idea is still very much work in progress. Clearly there are still huge problems with the UK economy, so impairments on the non APS book could in fact be higher than the bulls are assuming. It is also still not entirely clear how risky the assets outside the APS book actually are. Nevertheless, preliminary work suggest an NAV per share for LBG of 100-120p could be achievable by 2011. And when you consider that this is likely to mark the bottom of the impairments cycle and the bank will have a quasi monopolistic position with the domestic mortgage market, it is not hard to imagine a 1.5-2X multiple of this NAV, implying 175-250p potential value.