A traditional metric is broken.
You just can't trust bank balance sheets. That's not me saying that, but no less than the Governor of the Bank of England, Sir Mervyn King. More specifically, in a speech in Cardiff last week he said:
"I am not sure that advanced economies in general will find it easy to get out of their current predicament without creditors acknowledging further likely losses, a significant writing down of asset values and recapitalisation of their financial systems."
That came straight after advising UK banks to make use of the window of opportunity provided by the Funding for Lending Scheme, which runs until the end of 2014, to restore their capital. There can be little doubt that Sir Mervyn was including UK banks in his comments.
It's a view shared by the market. Shares in Barclays (LSE: BARC), which reported third-quarter results today, are trading at barely more than half current net asset value (NAV). Lloyds (LSE: LLOY) shares are about 0.6 times NAV at the half-year, while the metric for RBS (LSE: RBS) is a derisory 0.2.
Only HSBC (LSE: HSBA) and Standard Chartered (LSE: STAN) trade at respectable multiples to their NAV, at 1.1 times and 1.4 times respectively.
This isn't how theory says it should be. Broadly speaking, a bank's shares should trade around or somewhat above NAV. If the assets were liquidated and liabilities paid off, then what's left should be equal to net assets. The franchise value of the ongoing business might roughly offset the cost of undertaking a liquidation.
Put another way, if the individual financial assets and liabilities go into the balance sheet at their true fair value, as the accountants would have it, then the total net assets should be the true fair value of the business. That works for banks because financial assets and liabilities make up the bulk of their balance sheets.
What has gone wrong for this connection to break down? There are a number of factors:
1. Earnings. Losses and one-off write-downs have hit banks' earnings and so broken the historic relationship between price-to-earnings and price-to-NAV (or book value);
2. Dividends. The absence of dividends from RBS and Lloyds is an obvious drag on their shares. Barclays' yield, at around 3%, is some rational support for its share price (HSBC and Standard Chartered yield 4.3% and 3.5% respectively);
3. Asset quality. Like Sir Mervyn, the market suspects banks may have to write off more assets. They fear banks have shown forbearance to borrowers in order to avoid recognising losses (though low interest rates have also reduced defaults compared with previous recessions). Lloyds and RBS have made good progress in shedding problematic assets such as commercial property, but still have substantial portfolios of vulnerable assets;
4. The eurozone. Bank shares tend to move in tandem with sentiment towards the eurozone. Both Lloyds and RBS have sizeable businesses in Ireland, and all the banks have direct and indirect exposure to Europe;
5. Contamination. The UK banks are vulnerable to the collapse of a European bank and the chain of contamination that would ensue. Sir Mervyn's remarks are especially pertinent to European banks;
6. Complexity. Financial derivatives make up a third of RBS's total assets and 30% of Barclay's, in each case the single largest balance sheet item. Post the financial crash, investors are rightly suspicious of derivatives;
7. Legal liabilities. Banks have incurred massive legal liabilities for past indiscretions such as Libor-fixing and PPI mis-selling. Barclays is now under investigation for payments made in its 2008 capital raising and its US energy trading business. There is no certainty where or when the stream of legal claims will end;
8. Regulatory capital. Though the banks all have healthy-looking capital ratios on paper, Sir Mervyn's comments make clear that the regulators would like to see them raising more capital. That weighs on the shares.
On the positive side, the discount to net assets at RBS, Lloyds and Barclays is an indication of the upside potential. RBS and Lloyds are making progress in their rehabilitation, and Barclays has a new management team in place. But banks are still a risky investment.
One investor who saw the writing on the wall before most was Invesco Perpetual's Neil Woodford. He shrewdly got out of banks before the financial crisis. To discover where he is investing now you can download this free report from the Motley fool "8 Shares Held By Britain's Super Investor".
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> Tony owns shares in HSBC and Standard Chartered but no other shares mentioned in this article.The Motley Fool owns shares in Standard Chartered.