Bank Stocks’ Fed ‘Destruction’ Will Hit Hard In 2013

Bank Stocks’ Fed ‘Destruction’ Will Hit Hard In 2013
News
Like Us On Facebook
Like Us On Facebook

Investors in the largest U.S. banks should prepare for Federal Reserve policies to turn decidedly against their favor, regardless of announcements coming from the Central Bank on QE3.

That’s because the Fed’s near zero interest rate policy – expected to continue until at least 2014 – is likely to swing sharply from an earnings subsidy to a substantial hit in coming quarters.

After years of analyst warnings, net interest income, the positive difference a bank earns by extending loans and funding them with deposits will fall sharply in coming quarters, cutting interest-based earnings that count for between 40% and 70% of revenue at America’s largest banks.

Recently, top performing banks like Wells Fargo (WFC) have warned of a fall in interest earnings in forecasts. Meanwhile, as the issue emerges more clearly in coming quarters, Jim Sinegal, a large cap bank equity analyst at Morningstar, says the issue “might even be the biggest factor to what normalized bank earnings are,” as investors continue to wait for a sector-wide earnings recovery.

While the Fed has pushed interest rates and U.S. Treasury bond yields to record low levels, the negative impact of those policies on interest-based bank earnings has been muted by one-time factors that are running dry. As banks enter 2013, there will be little to cushion against the earnings drain. In fact, the longer the Fed keeps rates low, the worse the problem is likely to get.

The good news for investors is a proper understanding of interest rate dynamics on earnings will help to discriminate between the banks that see the biggest hit and those that are in a position of strength, as the sector heads into a murky 2013.

Net interest income is likely to create clear earnings contrasts between players like Wells Fargo (WFC), JPMorgan (JPM) and Bank of America (BAC) – whose earnings could suffer – as Citigroup (C), Capital One (COF), US Bancorp (USB) and Discover Financial Services (DFS) come out relatively unscathed.

Four years into the crisis and Fed easing, net interest income has largely been a boogeyman for bank earnings even if logic implies that record low interest rates should already be a problem.

For instance, as rates fall sharply, it was correct to assume banks would get less interest earnings on their loans and holdings of corporate bonds and Treasuries. But while yields on those of interest earning assets have fallen at or near record lows, the net revenue banks have earned is up sharply from pre-crisis years when rates were much higher.

The reason is while interest earnings have fallen by up to 50% since the Fed stepped in, the cost to fund those assets – interest expense – has dropped at an even greater rate. For banking giants like JPMorgan, Bank of America and Wells Fargo, faster falling interest costs than earnings mean net interest income actually more than doubled in some cases [earnings are colored by large acquisitions such as Washington Mutual, Merrill Lynch and Wachovia].

A few factors have helped.

The assets that banks earn interest on have relatively long maturities, in contrast to funding sources like deposits and short-term borrowings, which adjust quickly to changing rates. It means banks hold loans or securities carrying pre-crisis yields against post-crisis low expense. Meanwhile, banks have been redeeming high-cost borrowings, effectively refinancing at lower interest rates. But those, and other factors like the write up of acquired assets from crisis-time mergers are all running dry, as pre-crisis assets mature, refinancing opportunities diminish and writeups slow. [Interest margins are already trending lower]

“We are at the point now where we continue to see net interest margins under pressure,” says Fred Cannon, a director of bank research at KBW.

Cannon says declining interest earnings and margin pressures are poised to accelerate in 2013, with the prospect that the Fed’s maintenance of low-rates becomes a growing problem with each passing year. “Every year that you get farther and farther in this rate environment it gets harder to find offsets,” he adds.

On Tuesday, Wells Fargo chief financial officer Timothy Sloan warned of the problem in a presentation at the Barclays Global Financial Services conference, highlighting that the bank’s portfolio of bond securities carrying pre-crisis yields faces maturities that will push interest earnings lower. Wells Fargo now expects interest margins to fall 17 basis points and resemble year-ago levels in the third quarter.

Sloan highlighted two key factors: declining gains from the write up of credit-impaired loans acquired during the crisis [Wells Fargo bought Wachovia in 2008] – and a run-off of higher-yielding debt securities.

Previously, those factors helped Wells Fargo more than double net interest earnings since 2007. While interest earnings have risen modestly as a result of the Wachovia acquisition, interest cost is off roughly 60% in the past five years. For JPMorgan, the liquidation of its ‘Chief Investment Office’ after a $5.8 billion trading loss may be a similar earnings hit.

“This is the reality of a low interest rate environment. Sooner or later, it catches up to you,” says Nancy Bush, the head of bank research firm NAB Research. “We are at sort of coming to the point of greatest destruction over the coming year,” she says.

Cannon of KBW highlights Wells Fargo as the most exposed large cap bank to the negative impact interest rate dynamics. In contrast, he counts credit card lenders like Capital One and Discover Financial, and US Bancorp, which earns a lot of fee-based revenue, as banks that may come out relatively unscathed. [If you haven't noticed, card rates aren't much changed by Fed policy]

A way for Wells Fargo and other large cap banks to cushion against falling earnings would be to significantly ramp up loans, which carry an earnings opportunity even at 4% to 5% rates compared with zero cost deposits, notes Cannon. However, as CFO Sloan indicated on Tuesday, extending loans at record low rates carries a big risk if rates do rise sharply, signaling that CFO’s and investors face a bit of a guessing game on Fed policy, that’s tempering animal spirits.

Meanwhile, some lenders like Citigroup may have seized upon four years of beneficial Fed policy to prepare for what may be an industry-wide earnings drain.

Bush of NAB Research notes low rates have helped Citigroup carry non-performing assets at a low cost, as the bank purges its balance sheet of toxic assets. Even after divesting $600 billion of $850 billion in CitiHoldings toxic assets since 2009, the unit still absorbs 25% of the bank’s capital but represents just 10% of assets. Without low rates, it could have been much worse and because of dogged divestiture and reinvestment efforts by CEO Vikram Pandit, Citigroup may be in a uniquely strong position were rates to remain low for a long period of time.

Fearing a third Fed easing effort would signal the U.S. is headed into a Japan-like era of low growth, interest rates and bank earnings, Sinegal of Morningstar highlights Citigroup’s emerging market exposure as an opportunity. It may be a differentiating factor in coming years as Sinegal’s not very optimistic on the outlook for U.S. rates and their impact to bank earnings.

“I wouldn’t be surprised if the next three years look a lot like the last three years,” says Sinegal.

via The Street

Share Tweet
React
Like Us On Facebook
Like Us On Facebook

Julian Sonny

From the sandy beaches of Hawaii, to the streets of New York: Julian has seen it all. His lifetime of travels has given him a broad scope of knowledge and an eclectic taste unlike any other in the tri-state area. Julian has often been compared to cultural icon, The Rock, because of his unequivocal work ethic and warrior-like stature.

More In News

World Emily Arata

This Hilarious ‘Grease’ Parody Is All The Convincing You Need For Legalized Weed

Sandy and Danny have never looked quite as marijuana-friendly as they do in 4 Twenty Today’s shot-for-shot parody of “You’re the One That I Want” from “Grease.” 4TT is a weed-friendly YouTube news channel that wholeheartedly supports Florida’s Amendment 2, which decriminalizes marijuana use for those with medical marijuana authorization. Sandy’s new incarnation, Mary Jane, […]

Also On Elite

News

We’re F*cked: Senior Citizens Are Bringing Student Loan Debt With Them Into Retirement

Your student loans may be with you when you have grandchildren and a senior citizen’s discount. According to a frightening report released by the Government Accountability Office (GAO), over 700,000 American households headed by senior citizens still have student loan debt. What’s even scarier is that the number is growing. In 2005, people ages 65 or […]

Humor

Stop The Presses! Pierce Brosnan Actually Sucks At Goldeneye On N64 (Video)

Looking back, Goldeneye on the N64 is a frustratingly clunky mess that can’t really compare to other video games with two analog sticks at their disposal, but it managed to define a generation when it was first released. Based on the James Bond movie of the same name, the cheat codes, level design and Oddjob […]

TV

22 Times Lifetime’s ‘Saved By The Bell’ Movie Ruined My Childhood

Yes, I actually watched “The Unauthorized Saved by the Bell Story” on Lifetime. The TV movie was based on Dustin Diamond’s 2009 tell-all book, ”Behind the Bell,” which informed viewers of some little-known facts and drama about the series and, in turn, ruined my childhood forever. In case you didn’t watch it, which no one honestly […]

World

China Combats Texting While Walking Phenomenon With A ‘No Cell Phone’ Sidewalk Lane

Stopping in the middle of the sidewalk to text is never cool. But Chongqing, China, has found a way around the traffic-blocking hastle: separate lanes for those who walk and text. Although the installation probably isn’t permanent, city officials are using the divided sidewalks as a chance to bring attention to how disruptive using smartphones […]

Women

How Every Girl Eats On A Date Vs. How She Eats By Herself, The Salad Is Real

Until you’ve gotten to that point in your relationship when you’re comfortable late-nighting three-course meals in bed with your partner, eating together always feels like a first date. You want to make a good impression, you don’t want to do too much too fast, and you like to keep things clean. When eating alone, however, […]

Women

I Am Who I Am: Why Making The Wrong Choices Led Me To Self-Acceptance

All of our lives, we avoid being “that girl,” for some reason or another. I can’t tell you how many times I’ve reprimanded friends and made them promise not to be “that girl” while discussing our lives. The more I’ve avoided becoming “that girl,” however, the more “that girl” seems to find me. I lived […]