Narrowing rate gap may cut bank earnings
money.iwon.com
By Dan Wilchins
NEW YORK (Reuters) - Failing to heed the squeeze they suffered a decade ago, banks risk a drop in earnings from bad bets on U.S. interest rates.
A sharp drop in long-term interest rates has posed problems at U.S. banks that borrow at short-term rates and invest in higher-yielding, long-term assets, analysts said. Banks that had positioned for short-term rates to rise, rather than long-term rates to fall, may also get squeezed, they said.
"Banks learned a decade ago not to play with interest-rates, and they forgot that lesson in the last few years," said Richard Bove, an analyst at Hoefer & Arnett in Tampa Bay, Florida. "Now they're paying for it."
With the gap between short- and long-term rates likely to narrow, bank margins will generally be under pressure, a problem accentuated by wrong positioning, Bove said.
Knowing which lenders have bet on rates is nearly impossible to determine, but possible banks include Bank of America Corp. (BAC), Wachovia Corp. (WB) and Cleveland-based National City Corp. (NCC), analysts said.
These banks say they do not bet on interest rates, and are simply hedging. Many analysts agree.
But smaller banks like Astoria Financial Corp. (AF) have given a taste of what may come. The Lake Success, New York-based thrift in September said it would miss third-quarter earnings estimates, in part because of an unanticipated shift in short- and longer-term rates, which cut into its mortgage assets.
'RISKY GAMBLE'
In the early 1990s, many banks benefited from borrowing at rates much lower than what they earned on investments, said Nobel Prize-winning economist Joseph Stiglitz.
"The risky gamble ... paid off, and as a result the banks' balance sheets were greatly improved," Stiglitz wrote in a recent article in the Atlantic Monthly.
But the gambit may be near an end this time. Potential returns fell last quarter after longer-term rates dropped between the middle of the quarter and the end, and they could drop further -- threatening interest rate gains.
Even if earnings don't get hit, banks making money from interest-rate speculation might merit lower price-to-earnings ratios as their earnings are less predictable, said David Hendler, fixed-income analyst at independent research company CreditSights Inc. Nobody can accurately predict where rates are heading.
A bank that engages in interest-rate speculation does not typically broadcast it, but there are signs analysts look for. One is in a company's disclosures about derivatives.
According to a fairly new accounting standard, companies need to record on their income statement any gains or losses on derivatives positions that are not sufficiently protecting against an explicit risk, called "ineffective hedges."
These gains or losses are discussed in 10-Q statements, a company's quarterly filings with the U.S. Securities and Exchange Commission that can be found on the SEC Web site.
"If you see a lot of ineffective hedges, it's worth a question to the company," said Gary Gordon, an equity research analyst covering mortgage companies at UBS Warburg.
DERIVATIVES POSITIONS
Take a look at National City. According to its August filing, the bank recognized hedge gains of $141 million in the second quarter. After taxes, that's about $92 million, or nearly a quarter of its $392.8 million profit in that period.
For some analysts, that suggests speculation. Several said the figure raised questions about National City's hedging strategy, and the extent to which it might be taking on risk.
As a policy, the company does not try to make money from interest rate swings, and hedges its exposure to rates, said Tom Richlovsky, treasurer at National City.
"We're not a trading house, and we're not in the business of speculation," Richlovsky said.
Looking at how derivatives positions compare to underlying risk can suggest interest-rate positioning as well.
The size of Wachovia's derivatives positions fluctuates much more than its loans and core deposits, indicating there might be opportunistic positioning bordering on speculation, Hendler said.
Derivatives varied some $89 billion in notional value from the third quarter of last year through the first quarter of this year. Its loan book has varied by about $10 billion, and core deposits varied by about $9 billion.
Mary Eshet, a spokeswoman at Wachovia in Charlotte, North Carolina, said the bank does not bet on interest-rates. She said some hedging demands that the size of interest-rate derivatives far exceed the value of the underlying exposure.
BANK OF AMERICA
Bank of America is likely past its biggest bets. "The bank was very aggressive, and it paid off in spades," said Steve Gresdo, an analyst at Second Curve Capital in New York.
But as of the last quarter, it was still positioned for a sharp gap between short- and long-term rates, an equity analyst said.
Changes in BofA's net interest margin suggests it is taking positions, said John Otis, fixed income analyst at Deutsche Bank Securities. Net interest margin, a measure of net return from interest-bearing assets, is net interest income divided by interest-earning assets.
Big swings suggest a possible increase in risk. In the case of BofA, its net interest margin as of the second quarter has risen 0.54 percentage points to 3.74 from 2000, Otis said.
Part of that is from changing the composition of its balance sheet to enhance profitability, but part of that is also likely from interest-rate positioning, Otis said.
Eloise Hale, a spokeswoman at Bank of America, said the company has hedged against a weaker economy and resulting rates, and is not engaging in speculation. |
