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BREAKINGVIEWS-UK bank upstarts are already priced for downturn

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)

LONDON, Aug 17 (Reuters Breakingviews) - Foreigners might suppose cricket is Britons’ most hallowed pastime, but London dinner party guests know that it’s more likely to be property speculation. The passion is not shared by investors in buy-to-let focused banks, such as Aldermore, whose shares have generally underperformed those of high-street stalwarts in the past three months. Their valuation may, however, have fallen too far too fast.

Changes to stamp duty, extra charges on purchases of second homes, and falling mortgage interest tax relief have depressed rental yields and demand for buy-to-let mortgages. These loans now account for 14 percent of all mortgage advances, compared with around 20 percent in the first quarter of 2016, according to the Bank of England. As a result, Aldermore, Virgin Money , and OneSavingsBank are trading between 7 and 8 times expected 2018 earnings compared with a multiple of 10 for Lloyds or 15 for Royal Bank of Scotland.

Yet the upstart banks have growing loan books, high returns on equity, and none of the restructuring charges or fines for misconduct that S&P Global Ratings estimates cost bigger peers some 66 billion pounds since 2011. The newcomers also generally specialise in dealing with professional landlords, who are better able to cope with increased tax complexity and enjoy the benefits of scale.

Challenger banks have scope to grow their business since, together, they account for less than 5 percent of the mortgage market. Loan growth may have slowed, but the buy-to-let market, which is currently worth 228 billion pounds, is still expanding, the Council of Mortgage Lenders says. And these lenders may have some built-in shelter from a housing market crash.

First, average loan-to-value ratios are modest, at around 64 percent. Second, the newcomers’ lowly valuations already anticipate a jump in impairments. Take Aldermore. If operating income hits consensus forecasts next year, annual loan loss provisions would have to more than quadruple from 2016 for the lender to trade, like Lloyds, at 10 times next year’s earnings, according to Breakingviews calculations. Yet analysts expect no worse than a doubling in such provisions. Lenders who are already priced for a downturn may be better able to weather one when it comes.

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- Economic uncertainty and fears of a property bubble have in the past three months weighed on UK banks that specialise in buy-to-let mortgages. Shares in Aldermore have fallen 9 percent over this period, to 231 pence, while those in Paragon are down 11 percent at 415 pence.

- UK house prices rose 4.9 percent in June compared with a year earlier, according to data published by the Office for National Statistics on Aug. 15. The annual rate of increase was 8.2 percent in June 2016.

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Editing by Swaha Pattanaik and Liam Proud