It’s all over for bank stocks

Up until last week’s major dose of reality, the UK banking sector had been basking in the sun.

This chart tells the story:

UK banking sector over the last six months

UK banking stocks in the last six months

Source: Digitallook

Bank stocks rose handsomely for five months, only to suffer a moment of panic when things kicked off in Cyprus.

But was it just a panic?

Today I want to suggest that the rise was all down to smoke and mirrors. It was a profit illusion extraordinaire.

Research out this week from accountants KPMG says that though bank profits may look good on paper, when you delve a little deeper, you see that profits were all but wiped out by exceptional items.

You know things like the personal protection insurance (PPI) repayments, regulatory fines and, more extraordinarily, the undoing of some rather dubious looking accounting practices. We’ll look into this accounting fudge in a minute.

The important thing is that investors are waking up to the con. It seems to me there’s still a lot of trouble ahead. And on top of a crumbling business, Europe is now looking to bank shareholders and bondholders to share the pain of previous misdemeanours.

I suspect that the run up in bank shares is at an end.

The relighting of the banking sector

According to KPMG, bank profits staged a remarkable recovery in 2012. The big five UK banks reported an increase of 45% in core profits.

Well, of course they did! It was mostly at the expense of the rest of us. I mean, with the central bank making practically limitless cash available and practically for free – the banks were armed with liquidity to go out there and place their bets.

And with interest rates screwed to the floor, there were plenty of opportunities for profitable investment; not least because low rates helped keep bad credits down among their largely over-borrowed customer base.

But digging a little deeper, the eagle-eyed accountants at KPMG say things aren’t quite as rosy as they first appear. Mistakes have been made both on the ‘casino’ side of things, and the retail side.

Reprehensible behaviour gets its reward

We all know about the disastrous Libor rigging scandal. Fines are still rolling in for that. What’s even more sickening for shareholders is that the banks probably didn’t even profit from these manipulations. It seems that what one team in the bank made, another team lost. At other times, the manipulations were just doing favours for mates in other banks!

Whether they lost or won, the slack attitude to playing by the rules cost the banks a collective £5bn.

But it wasn’t just the casino operations. On the retail side of the fence (not that there is a fence yet!), the bankers were just as careless. In fact, in many ways, mis-selling of PPI and interest rate swaps is even more reprehensible.

I mean, pushing products that were highly unlikely to be of use to punters – or indeed, in the case of interest rate swaps, likely to be massively detrimental – was a disgrace. Of course, the PPI rebates were supposed to have been done and dusted by now. But no. According to the report, PPI losses ramped up 50% last year – £7.4bn, it cost them!

The banks must be praying that all those miserable PPI punters have by now been dealt with. After all, they’ve got the interest rate swap mis-selling lot lining up at the door now!

But the third major profit malfunction during 2012 is probably the most interesting. This one wasn’t down to the casino or the retail side of the business. This was a scam dreamt up by the accountants at HQ.

An audacious accounting fudge

Like I said at the beginning, at its worst, banking is largely a game of smoke and mirrors. And it’s especially so when a bank is in trouble. During the crisis of 2008, most of the banks were looking down the barrel of a loaded gun. They had to raise funds to bolster balance sheets – but who was going to invest when the losses looked astronomical?

So the accountants came up with a rather audacious little plan. Because of the nasty situation, the bonds in many of the banks were selling at pennies on the pound. Basically, it wasn’t clear that bank bondholders would get all, or any of their money back.

Let’s say a bank’s bonds were trading at a 30% discount to face value. That effectively meant that they were trading at a 30% discount to the liability shown on the bank’s balance sheet.

And so, the clever accountants reasoned they could mark down the liability on the balance sheet by 30%. After all, that was the market value of the debt! Now, you can’t just reduce your liabilities on the balance sheet, you have to put an entry through the profit and loss account. And that goes through as an ‘extraordinary profit’ – extraordinary indeed!

Of course, it was all an illusion. The only way to really make that profit would be to buy the bonds in the market and retire the debt.

Only they couldn’t do that, because they didn’t have the money!

Now, here’s the point: along with resurgence of faith in the banks, the bank bonds have been trading up rather nicely. And that means the accountants now have to reverse the profit entries they craftily put through at the height of the crisis. That means putting through extraordinary losses.

Well, at least the banks are now better placed to take the losses. But it’s of little compensation to shareholders; the better the banks perform, the greater the losses.

Where to next?

To my mind, there’s still a lot of bad news in the industry’s pipeline.

As I said earlier, we’re still to see the full fallout from the interest rate swap rigging. And then there’s Libor – regulatory fines are still being meted out, and litigation from clients (or even non-clients) could be catastrophic. These cases could keep the lawyers in clover for years to come.

Of course, the banks are downplaying the extent of the troubles ahead. That’s exactly what they did with the PPI scandal too. Remember, the banking industry is a game of confidence. They need to lay down the smoke and line up the mirrors, lest anyone catches on.

All I can say is good luck. With the EU increasingly looking to make bank shareholders and bondholders take the strain, it’s a sector to be avoided.

If you’re feeling bold, you could even short the banks. In fact, I might just re-open my short too. Stay tuned for news on that in a forthcoming issue of the Right Side.

• This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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