Why you should be wary of investing in banks

With bad debts on the increase, it's not a good time to be exposed to the UK consumer. So there are several FTSE 100 you should avoid investing in at the moment, including banks.

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Markets are holding their breath this morning, waiting to see if the Bank of England will raise interest rates or not.

We can't see any reason for the Bank not to but we are in the minority. The only point that all commentators agree on is that this will be the most hotly-contested rate decision for a long while.

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But regardless of what happens later today, we don't think it's a good time to be exposed to the UK consumer which means there are several FTSE 100 companies you should be avoiding at the moment...

One sector we'd be extremely wary of just now is the banking sector. Although banks have been reporting record profits, bad debts are also mounting fast. Barclays this morning has reported that 'impairment charges' rose a whopping 50% in the first six months of this year, to £1.06bn. The lion's share was due to UK Barclaycard customers having more trouble paying their debts.

Yesterday Lloyds TSB also reported a jump in bad debts, which rose 20% to £800m across the group as a whole, from £666m last year. As with Barclays, the majority of that was down to consumer bad debt at its UK high street banking business, which rose 16% to £632m. That was compared to a rise in pre-tax profits of just 2% at the same unit.

HBOS and HSBC also reported sharply higher bad debts earlier this week and it seems likely that Royal Bank of Scotland will follow suit in its interim results tomorrow.

We'll look in more detail at the banking sector in a forthcoming issue of Money Morning once the latest reporting round is over - but it doesn't look good, particularly for the banks with high exposure to the UK consumer, like Lloyds and HBOS.

Banks are trying to put a brave face on things. Lloyds reckons that bad debts will stabilise in the second half of the year due to its tighter lending criteria. In the first half of 2006 almost all new personal loans and four-fifths of new credit cards were sold to existing customers - so the theory is that the company should have a better grasp of the credit risk it is taking on.

But Lloyds also pointed out that "the rate of growth in the number of customers filing for bankruptcy and Individual Voluntary Arrangements (IVAs) doesremain a key factor in the outlook for retail impairment."

IVAs are basically agreements whereby a struggling borrower can come to a deal with their creditors to pay off a set amount of their debt, with the rest being written off. (Much earlier this year, MoneyWeek wrote a piece about how IVAs work and which companies deal in them you can read it here: How to profit from bankruptcy (/file/7796/how-to-profit-from-bankruptcy.html)).

It's not surprising that many consumers have been taking advantage of the newly relaxed bankruptcy regime. Especially when you consider that many of the customers in question probably wouldn't have been considered an acceptable credit risk if monetary conditions weren't so lax.

Crucially IVAs only apply to unsecured lending - hence the rapid retreat from the credit card and personal loans market being shown by banks these days.

But Lloyds' optimism seems a little premature to us. Consumers remain heavily indebted, and living expenses are mounting all the time amid soaring energy bills. Meanwhile, IVAs are still being aggressively marketed as a relatively pain-free way to escape your creditors. We have a feeling that a lot more people will be tempted down that route before things start to improve.

So banking isn't the most attractive sector to be in at the moment. Mind you, there are worse the housebuilding sector springs to mind.

Sector heavyweight Wimpey reported a 25% rise in pre-tax profits to £152.3m earlier this week. But despite sales hitting a 25-year record of 7,822 homes, the group said that price rises were becoming more difficult to achieve, particularly outside London. The average selling price fell 5% to £175,500 from £184,600 the year before.

Wimpey has some international exposure, which you might think would make it less risky to invest in. The trouble is, the other market Wimpey is exposed to is the US, where the housing slowdown is really starting to bite.

The US unit Morrison homes has seen forward orders dive by 16% and visitors per site fall by more than 30%. Wimpey is also trying to be optimistic - but with US consumers even more heavily indebted than their UK counterparts, it's almost certain that the bad news from the US has only just begun.

On a final note, just before today's interest rate decision, we hear another worrying point on inflation. According to the British Retail Consortium, prices in shops rose year-on-year for the first time since September 2005. Prices rose 0.69% in July, the largest rise seen since July 2004, when prices rose 1.18%.

One of the main factors holding inflation back in the UK has been the continuing decline in retail prices. As we said in yesterday's Money Morning (Why the Bank of England should raise interest rates (/file/16239/why-the-bank-of-england-should-raise-interest-rates.html)), once shops start to raise prices in reaction to rising costs, consumers may start to notice just how expensive life is becoming and ask for higher wages. That would mean higher inflation which would in turn lead to more interest rate hikes.

And that would be bad news for both banks and builders.

Turning to the wider markets...

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The FTSE 100 rose 51 points to 5,932. Broadcaster ITV rose 5% to 101.5p on bid rumours ahead of next week's interim results. Miners were also ahead as Xstrata posted strong first-half results. For a full market report, see: London market close

Over in continental Europe, the Paris Cac-40 closed 78 points higher at 5,026. The German Dax-30 rose 84 points to 5,680.

Across the Atlantic, US stocks rallied as Procter & Gamble and Time Warner both posted forecast-beating earnings. The Dow Jones Industrial Average gained 74 points to close at 11,199, while the S&P 500 rose 7 to 1,278. The tech-heavy Nasdaq climbed 16 to 2,078.

Overnight in Asia, the Nikkei 225 rose just 6 points to 15,470. Toyota was among the main risers on hopes that US earnings will have picked up in the first quarter. Shipping companies were down as two firms - Mitsui OSK Lines and Kawasaki Kisen Kaisha - cut their profit forecasts for the year, amid rising fuel costs and falling transport rates.

Oil prices were lower in New York this morning, with crude trading at around $75.50 a barrel. Brent crude was also lower, trading at around $76.50.

Meanwhile, spot gold was little changed, trading at around $649.20 an ounce after heading as high as $655.45 on Wednesday. Silver rose as far as $12.27 an ounce before easing back to trade at around $12.05 an ounce.

And in the UK this morning, Halifax has reported that UK house prices rose 0.2% in July, taking the annual rate of increase to 8.8%. The rise comes after declines in May and June - in the three months to the end of July, prices actually fell 1%.

And our two recommended articles for today...

What a penny can tell us about inflation

- If you dropped a penny, would you bother to pick it up? Probably not, says Richard Benson of the Specialty Finance Group. Rampant inflation means that the zinc in a US penny is now worth more than the penny itself. To find out exactly what the real rate of inflation is and what's the best inflation hedge read: What a penny can tell us about inflation

Dodgy shortcuts first-time buyers should avoid

- Priced-out first-time buyers are resorting to ever more desperate means in order to get a foot on the property ladder. Huge numbers are already holding down two jobs or relying on help from parents. Some are even tempted to invest in property abroad or buy with a complete stranger, but schemes such as these can be very risky, as MoneyWeek's Jody Clarke pointed out in a recent issue. To find out what a first-time buyer's best option is now, read: Dodgy shortcuts first-time buyers should avoid

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.