Woodford and Buffett were right about banks

Neil Woodford has built a significant record of out-performance through some rather prescient sectoral calls across his career, including the sale of all bank shares well before the financial crisis hit.

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A little over two years ago, Woodford once again warned about the banks when he sold HSBC only months after launching his equity income fund. He cited "unquantifiable" fines as his mains source of discomfort.

Fines, fines everywhere

Unfortunately for shareholders in RBS(LSE: RBS), it looks like Woodford's concerns were, once again, bang on the money. Analysts expect the bank to set aside between £4.2bn and £9bn in additional provisions to cover the mis-selling of residential mortgage-backed securities in the US pre-08.

That's a pretty huge range, but its not surprising given the eye-watering, though as yet unconfirmed, $14bn fine facing Deutsche Bank for a different brand of mis-selling. And this isn't the first time the US government has slapped foreign banks with astronomical fines.

The banks are still easy pickings for the likes of the Department of Justice, and I fear any number of misdemeanours could be lurking in the histories of these vast institutions.

Further to the threat of fines, however, is the issue of transparency.

Mind-bending balance sheets

The largest banks are global behemoths, with incredibly complicated operations and, in my opinion, head-scratching finances, largely due to the impact of derivatives.

Warren Buffett has long-referred to the complicated deals as "weapons of financial mass destruction," a quote that has been labelled a little dramatic by some. Sticking to his guns, Buffett issued a fresh warning at Berkshire Hathaway's AGM earlier this year by recounting derivatives at reinsurance vehicle Gen Re that lost £400m. Munger added the following context:

"The accountants blessed that big derivative position as being worth a lot of money. They were only off by, what, a few hundreds of millions."

If the experts can't figure them out, what chance do DIY investors have?

The Bottom Line

Many investors buy bank shares fully aware of the aforementioned problems, because they believe historically low valuations more than compensate for any future risk, but I'm not so sure I agree.

In theory, a ratio below one means you could profit from breaking up the bank and selling off its assets. Practically, it implies the market doesn't trust the quoted numbers and/or expects lower returns in the future.

Before the financial crisis, some banks would trade at two times book value, implying massive upside if things went "back to normal." But we're living in a different world. 2008 has, quite rightly, resulted in increased financial regulation and new countermeasures, including an increase in risk officers, that will likely drag down overall returns for years to come.

That said, the vast majority of us rely on banks and that isn't going to change anytime soon, implying this may be a good time to take advantage of poor sentiment. Investors who find banks compelling should take a closer look at retail banks, who simply take deposits and lend money to their own customers, profiting from fees along the way.

Personally, I believe the value on offer is seductive, but given the complexity of these businesses I can't quite bring myself to invest.

After all, the human mind isn't always logical when analysing investments. It's easy to be seduced by bargain-bucket valuations only to find yourself owning something you don't quite understand. We all like to think we are unique, but the vast majority of investors make the same mistakes time and time again.

The first step in fighting these inevitable fallacies, however, is to be aware of them. We've asked analysts from all over the world to explain the most common mistakes that investors - be they experienced, green or inbetween - make.

Click here to learn from our mistakes!

Zach Coffell has no position in any shares mentioned. The Motley Fool UK has recommended Barclays and HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.