Five Bullets For The Banks!

We come up with five fears to trouble both customers and shareholders of British banks.

Habitual Fool readers will know that I'm not a great fan of Britain's banks, large or small. As an ex-banker, I've seen from the inside how banks eagerly fleece their customers in order to enrich their shareholders. Then again, as an investor, I can see the attraction of owning banks and, in the past, I have invested heavily in a number of them.

However, after reading a book last March which accurately predicted the liquidity and credit crunch*, I decided to bail out of financial firms before the turmoil arrived. This turned out to be a very fortunate decision, as I watched the value of my former holdings in the likes of HBOS, Lloyds TSB and RBS collapse by up four-fifths (80%). Yikes!

Today, I own no financial shares, bar a small holding in HBOS which I acquired via an employee share scheme (and now worth a quarter of its former peak!). What's more, I have no intention of dipping my toe into the banking sector until there are clear signs that the banking crisis has run its course. Here are five reasons why I still fret about the stability of British banks:

1.    The collapse of mortgage lending

My first piece of bad news comes from the mortgage market, where falling house prices have scared off all but a few potential buyers. On top of this, tighter lending criteria and a lack of inter-bank lending have led to a severe slump in home loans. Indeed, I expect lending in June to be down by two-thirds (67%) on that recorded in June 2007.

This mortgage drought is very bad news for British banks, because they rely heavily on new borrowers coming through the door. This enables them to cross-sell other high-priced products to new customers, such as life and health insurance, home insurance, mortgage payment protection insurance, investments and so on. Thus, without a steady stream of fresh blood to feed on, sales of insurance and investment plans are also likely to decline, hitting bank profits.

2.    The Competition Commission and PPI

As I explained in The Death Of Rip-off Insurance, banks trouser up to £4 billion a year by selling rip-off accident, sickness and unemployment cover, known as payment protection insurance (PPI). After a lengthy investigation, the Competition Commission concluded in June that the PPI market was anti-competitive.

At present, the Commission is deciding what remedies it needs to put in place in order to improve consumer protection in the PPI market. Were the Commission to introduce a temporary ban or price cap on the sale of PPI, this would be a disaster for banks, as some make a tenth (10%) of their profits from selling this over-priced rubbish!

3.    The OFT and bank charges

Likewise, in Another Six Months In Limbo, I warned that British banks make perhaps £3.6 billion a year from punitive and unfair charges for unauthorised overdrafts. The Office of Fair Trading (OFT) has taken court action against eight leading providers of current accounts, in order to prove that their fines are disproportionate and, therefore, illegal.

If OFT wins its case, then it might order the banks to, say, halve these charges (as it did with credit-card fines). This would lose banks £1.8 billion a year, forcing them to raise charges elsewhere. However, I think the banks would struggle to recoup such a large sum from other charges, as this would lead to an exodus of customers. Therefore, a win for the OFT will mean reduced revenues for the banks.

4.    Bad debts from consumer credit

There has been a considerable rise in mortgage arrears and repossessions over the past twelve months, particularly among subprime loans. However, rising unemployment, falling disposable incomes and sliding company profits will lead to a surge in the number of individuals (and companies) unable to meet their debt repayments.

Indeed, this bad-debt problem is sure to spread to mainstream mortgages and other forms of credit, such as car and personal loans, credit and store cards, and so on. Thus, the banks will be hit by a wave of arrears, defaults and write-offs in consumer credit (non-mortgage lending). Again, I expect this figure to amount to billions of pounds.

5.    Banks will need to raise yet more capital

The ongoing credit crunch was initially caused by banks' massive losses at the risky end of the lending spectrum. However, their portfolios are a long way from being clear of ropey loans and toxic securities. Thus, further write-downs and increasing bad debts will wipe out many more billions.

Indeed, the International Monetary Fund (IMF) has warned that, thanks to falling house prices and lower economic growth, global credit problems are far from over. The IMF believes that, having written off almost £250 billion of assets, there is still another £250 billion to go for banks worldwide. Ouch!

Thus, the banks will continue to take a beating for some time to come. Hence, in order to maintain their solvency, they will need to undertake further rounds of fund-raising, sell prized assets, or cut their lending even further. This will lead to yet more pressure on bank share prices, perhaps sending them to new lows.

In summary, the credit crunch began barely a year ago, so I believe that its repercussions will continue for at least two more years. Accordingly, I think that the bad news for banks and their profits is not done yet. Although Northern Rock may well be the UK's last bank failure (as well as the first), I won't be going near bank shares until their annual profits start to march steadily upwards again.

* A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Dr Richard Bookstaber (ISBN: 0471227277)

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