Troubled challenger banks: worth a punt?

Challenger banks have seen their shares plummet since Britain's vote to leave the EU. Is now the time to buy in, asks Sarah Moore.


Lenders may struggle, but investors have priced in disaster

In the three weeks since the UK voted to leave the European Union, shares in challenger banks Aldermore and Shawbrook have dropped by 32% and 40% respectively. These banks, relatively new to the market, are not yet especially well known. But they have spent the past few years quietly positioning themselves to fill the gaps left by high-street lenders, offering bank accounts which pay a higher-than-average level of interest and also providing niche mortgage products. Are their current low share prices a sign to steer clear, or is it time to buy?

Before 23 June, the argument for owning these mortgage specialists was "simple", says Lex in the Financial Times. They focused on the "fastest-growing lending niches" (such as buy-to-let mortgages) and had a projected return on equity in the mid-teens, "more than double some of their bigger rivals".

Aldermore saw profit before tax rise by 88% to £94.7m in 2015, and processed net loans to customers of £6.1bn, up 28% from the year before. "These specialist challenger banks have been such a success because of their deliberate focus on under-served markets," says Ian Gordon, banking analyst at Investec. For example, 60% of OneSavings Bank's gross loan book is made up of lending for buy-to-let and "small and medium enterprises" (SMEs).

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As well as tapping into these under-represented areas of the market, challenger banks have largely managed to avoid recent mis-selling issueswhich have hit the big banks, such as the payment protection insurance scandal and associated fines. (Although Shawbrook will be hit by a £9m "bad loans" charge in the second half of this year, after it was discovered some of its loans didn't meet lending criteria.)

However, post-Brexit, the challenger banks have fallen victim to their own success in a way. As we pointed out last week, the Bank of England has warned that challenger banks are the most vulnerable to a post-Brexit downturn, precisely because they have been willing to make these sorts of riskier loans in the first place.

Overall, the smaller banks have lent less than mainstream banks to the commercial property sector, for example (a mere £17bn relative to big banks' £85bn) but loan-to-value (LTV) ratios are higher. This means it would take a smaller fall in prices to put these loans into negative equity. And looking beyond Brexit fears, the government's recent crackdown on the buy-to-let industry might also have had an impact on share prices.

However, the sharp fall in the bank's prices does seem overdone. As Lex points out, to get from Aldermore's current book value to the one implied by its current share price, broker Numis reckons that bad-debt charges would have to rise 28 times the reported 2015 figure. Lex also draws attention to mortgage specialist Paragon's experience during the financial crisis in 2008/2009. At the time, Paragon reported impairments of 1.7%.

But actual losses peaked at 0.33%. LTV ratios in buy-to-let mortgages are now lower than in 2008, with average debt interest covered almost twice over by rental payments. It is also highly likely that interest rates will stay low for the foreseeable future, which implies that borrowers will continue to take out cheap mortgages and remortgage their properties.

But "even though we reckon a recession has been well priced in", says Emma Powell in Investors Chronicle, "the issue with these challenger banks is they are an almost one-way bet on the direction of the property market". The industry thus relies on a robust UK economy with rising demand for loans (before even taking into account market saturation and competition), and may not be a bet for the long term. However, at these prices, they may well be worth a punt as Lex concludes, "yes, lenders probably face a downturn. But investors are pricing in a disaster."

Sarah is MoneyWeek's investment editor. She graduated from the University of Southampton with a BA in English and History, before going on to complete a graduate diploma in law at the College of Law in Guildford. She joined MoneyWeek in 2014 and writes on funds, personal finance, pensions and property.