The Federal Reserve’s policy of keeping interest rates persistently low, which has helped boost bank earnings over the last six quarters, is beginning to make it harder for the biggest U.S. lenders to make money.
Firms including JPMorgan Chase & Co. and Bank of America Corp., which have benefited from record low costs of funding mortgages and other assets, face a squeeze on their net interest margins -- the difference between what they pay to borrow money and what they get for loans and on securities. Analysts say the margins may have peaked in the first half and that banks will struggle to replace high-yielding assets as they pay off.
The Fed’s near-zero target rate for interbank overnight lending that has buoyed profits for so long will have an opposite effect in coming quarters, said Christopher Whalen, a Federal Reserve Bank of New York analyst in the 1980s and co-founder of Institutional Risk Analytics in Torrance, California.
“That’s the gift from the Fed,” Whalen said of the rate. “But at the same time, the cash flow on your assets eventually starts to re-price and match the low-rate environment. The zero-rate environment is eventually bad for everybody.”
Net interest margins fell by 26 basis points to 3.06 percent at New York-based JPMorgan from the first to second quarters, 17 basis points at Citigroup Inc. to 3.15 percent and 16 basis points at Bank of America to 2.77 percent, according to company reports. A basis point is 0.01 percentage point.
The reduced margins, along with lower lending volumes, translated to a drop in net interest income of $1.02 billion at JPMorgan, the second-largest U.S. bank by assets and the largest by market value. Net interest income fell $849 million at Bank of America, the biggest lender by assets, and $522 million at New York-based Citigroup, which is third.
“It’s a massive issue for the industry, impacting banks at different timing,” said Matt O’Connor, an analyst at Deutsche Bank AG in New York. “The universal banks -- Bank of America, Citi and JPMorgan -- are feeling the pressure now and will continue to feel pressure for the foreseeable future.”
Brian Moynihan, 50, chief executive officer of Charlotte, North Carolina-based Bank of America, told analysts on a July 16 conference call that the “sustained low-rate environment” was hitting revenue and earnings and will continue to affect margins. JPMorgan CEO Jamie Dimon, 54, told analysts the day before that the bank’s net interest margin will continue “coming down a bit as we reposition the portfolio.”
Wells Fargo & Co., the fourth-biggest bank, reported that net interest margin increased by 11 basis points to 4.38 percent in the second quarter, which the bank said was the result of higher-than-expected income from soured mortgage loans.
By lowering its target rate to almost zero in 2008, the Fed helped save many banks from collapse. The move reduced the industry’s average cost of funding mortgages and other interest- earning assets to 1.03 percent in the first quarter of this year, the lowest rate on record according to the Federal Deposit Insurance Corp., from 3.58 percent in the third quarter of 2007.
While it also depressed the yield banks earn on their investments and loans to 4.86 percent from 6.93 percent over the same time period, the net interest margin hit a seven-year high of 3.83 percent in the first quarter, according to the most recent FDIC data available.
The Fed has signaled that slowing inflation and a sluggish economy will push any interest-rate increase into 2011. It said in a June 23 policy statement that “underlying inflation has trended lower” and repeated a pledge to keep the benchmark interest rate near zero for “for an extended period.”
The language led most economists polled by Bloomberg to predict the Fed won’t raise rates until the second quarter of next year. Futures traded on the CME Group Inc. exchange showed a 37.6 percent likelihood yesterday that the benchmark lending rate will be raised in April 2011. That likelihood was 55 percent a month ago.
“Once you get into this low-rate environment for 12 to 18 to 24 months, somewhere in there assets start re-pricing to the lower interest-rate environment,” said Marty Mosby, a Memphis, Tennessee-based analyst with Guggenheim Partners LLC.
Banks, reluctant or unable to lend, are shrinking their balance sheets. That’s starting to eat into cash flow at the biggest lenders.
‘No Loan Demand’
JPMorgan’s balance sheet was reduced by $121.8 billion in the second quarter to $2.01 trillion, which is also down from a peak of $2.25 trillion in the third quarter of 2008. Citigroup’s total assets fell by $64.6 billion in the second quarter to $1.94 trillion. Wells Fargo’s total assets, which were up $2.2 billion from the first quarter to $1.23 trillion in the second, have fallen from a peak of $1.31 trillion in December 2008.
“There’s no loan demand, and long-term rates have declined so much,” Deutsche Bank’s O’Connor said. “So as you look out over the next few quarters, it’s a potentially very dire situation for the overall industry.”
Loans generate some of the highest yields for banks, said Jason Goldberg, an analyst at Barclays Capital in New York.
“In an environment where loan growth is tough to come by, it’s a tough challenge,” Goldberg said in an interview. “When your highest-yielding asset isn’t there to put on the balance sheet, it’s tough.”
Goldberg said banks are getting squeezed as the yield curve, which charts the difference between rates on short- and long-term debt, flattens out. The spread between yields on three-month Treasury bills and 30-year Treasury bonds fell to 387 basis points July 23, down from 471 basis points January 11, the highest level in at least a decade, according to data compiled by Bloomberg.
Because most banks tend to fund their long-term investments such as 30-year mortgages with short-term debt, they benefit when short-term rates are lower and make less money when short-and long-term rates come closer together.
“Generally, the steeper the curve, the better,” Goldberg said. “It’s steep by historical standards, but it’s not as steep as it was earlier this year.”
Regional banks won’t start feeling the pain until later this year or early next year, partly because their reliance on deposits for funding has insulated them from broader market shifts, O’Connor and other analysts said. The average rate paid on checking-account deposits was 0.53 percent on July 13, the lowest level since February 2005, according to Bankrate.com.
‘Hit the Floor’
“We’ve hit the floor in deposits, you can’t go any lower, and your asset yields are declining,” said Nancy Bush, a bank analyst and co-founder of NAB Research LLC, an Annandale, New Jersey-based independent research firm. “So there’s only one way to go for the margin, and that’s down.”
PNC Financial Services Group Inc. said its cost of deposits in the second quarter fell to 71 basis points from 81 basis points in the first quarter and 125 basis points a year ago. Those lower funding costs won’t be enough to offset the yields the Pittsburgh-based bank is earning from securities, mortgages and credit cards, Chief Financial Officer Richard Johnson told analysts on a July 22 conference call.
“This downward trend reflects the continuing migration of the portfolio to lower-risk asset classes, such as U.S. Treasury and U.S. agency mortgage-backed securities, along with the impact of the lower-rate environment,” Johnson said. “Yields on securities will continue to decline as we replace maturities and prepayments with lower-risk securities.”
Johnson said the bank, the sixth-largest by deposits in the U.S., will generate lower yields and profit margins in the second half of the year.
“When banks can’t find yielding assets and their book is shrinking, the cash flow on their book is shrinking,” said Whalen of Institutional Risk Analytics. “Everybody’s starving to death.”