Why are the banks doing so well?


UK banksRemember the end of 2011? It was all doom and gloom. The year had been a torrid one for shares, and most particularly banking shares. And the pundits were predicting more of the same for 2012.

Banking shares had looked cheap in 2011, but they just kept getting cheaper. Many investors, including myself, got hurt trying to catch these extra sharp falling knives.

2011 was a terrible year for banks
The banks were suffering as the eurozone debt crisis rolled on through 2011, going from one disaster to another. First Greece, then Portugal, then Italy -- this seemed to be the crisis without end. With the prospect of billions of pounds of debt defaults, banks were the last thing to be invested in.

What's more, many banks had not recovered from the Credit Crunch of 2008 and their finances were still in a parlous state, with mountains of bad debt on their balance sheets.

And then there was the opacity of their accounts. Bank finances are a minefield of arcane terminology, from credit default swaps and core tier 1 capital to Libor and loan-to-deposit ratios. I'll be honest and say that I don't understand much of this, and I suspect most Motley Fool readers don't either.

This complexity was not only putting investors off -- in the words of Warren Buffett, "Never invest in a business you cannot understand" -- it was also making the banks very difficult to value.

Capitulation, followed by recovery
So bank share prices kept falling. By December, virtually everyone seemed to have given up on the banks. I certainly wasn't even bothering to check their share prices -- it was a capitulation point.

But since then, we have seen a remarkable recovery. Lloyds Banking Group (LSE: LLOY) is currently up 56% from its 2011 low, Royal Bank of Scotland (LSE: RBS) is up 51%, and Barclays (LSE: BARC) is up a whopping 73%. What on earth is going on?

Well, it is down to just one thing: the prospect of Armageddon in the eurozone, which was looming over everything in 2011, has dramatically receded. For that, we have to thank the ECB and its head, (Super) Mario Draghi. The Long Term Refinancing Operation (LTRO) has pushed down eurozone bond yields and has, quite simply, saved the day.

But there is still a long road ahead
However, this doesn't mean that the prospects for Britain's banks are going to suddenly improve. It is just saying that absolute disaster is now off the table. And that has been enough for the recovery in share prices.

But let's not delude ourselves. Last month, Lloyds reported a £2 billion loss for 2011. And RBS also posted a £2 billion loss, up from the £1.1 billion loss of 2010. Clearly, even though the immediate possibility of another major banking disaster has receded, it is still going to take a long time, and a lot of hard work, to clean up the mess after the Credit Crunch.

A worthwhile contrarian investment
Which leads us to the big question. Are the banks still worth investing in? Well, all three banks that I have mentioned still look cheap relative to their asset value. Lloyds is on a discount to net tangible asset value of 41%, RBS's discount is 50% and even Barclays is on a discount of 35%.

In the long term, I think these discounts will narrow. However, the road to recovery will not be a smooth one -- I suspect there will be more ups and downs to come.

Nonetheless, I would say the banks are a worthwhile contrarian investment for the patient, and for those with a stomach for fluctuations. If you count yourself as one of these, then by all means buy in. If not, then there are many other bargains available in today's stock market.

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