In pic-form — one drag on US bank earnings:
It’s the flattening US yield curve. And its antithesis — a steepening curve — is one of the things that helped recapitalise and propel the banks to super-profits last year; part of what banking analyst Meredith Whitney dubbed the “Great Government Momentum Trade.”
We bring it up because Keefe, Bruyette & Wood’s have a note out on the subject.
In it, the “specialists in financial services” ask their analysts to visualise bank earnings in light of the 10-year US Treasury’s recent drop to the 2.6 per cent range, and an economy that does not appear to be improving. In other words — earnings in the context of a flattening yield curve.
The analysts’ (summarised) answer:
In this scenario analysis, our adjusted normalized EPS estimates assume a median hit to our normalized [Net Interest Margin] of 15 bps back to 3.65% (at about 2Q10 levels). The analysis does range pretty significantly across our universe from -160 bps (SIVB) to +24 bps (CATY). This translates into a median 5% decline in spread income in our adjusted normalized estimates versus current normalized estimates and consequently a median 11% hit to normalized EPS.
Still (probably) profitable then, but not quite as much.
The numbers may be a bit wonkish but we think they’re interesting as part of an over-arching theme regarding declining bank profitability in the context of low interest rates, financial reform, Basel, still lacklustre loan demand, and subprime throwbacks. Points all touched upon by KBW:
The issue of timing is another wrench in the gears of valuing the banks’ earnings streams. While we have different time to normalized estimates for each of our banks already, these timing differences are mostly based on credit. That said a prolonged, compressed yield curve extends the timing to normalized earnings for all of our banks no matter how far they are through the credit cycle. A low curve also implies that the economy is not growing and credit is not improving putting an additional burden on the banks ability to reach normalized earnings.
The good news in this — the corollary you might say — is the ‘loaded spring’ concept.
If a flattening yield curve, declining credit and a stagnating economy are a drag on bank earnings — should all three pick up, well then . . . we’ll let KBW explain:
While we believe there is more potential downside risk to our normalized earnings, it is important to note that we think the earnings power from our legacy normalized earnings analysis still exists – it just may take longer than expected to materialize. While FinReg and potential future regulation represents an implementation of a permanently higher cost environment, the banks have very significant operating leverage.While we talk about the NIM’s in this report, the banks also have historically low (in the high 30% range) loan utilization rates and significant human investments in the workout process, so ultimate loan growth, at the least, should not be accompanied by any significant expenses. Plus, many banks have asset management businesses where assets under management could improve in a better environment and where the money market funds are currently foregoing a fee. In addition, the mortgage business, despite higher rates, would benefit from greater activity. On the expense side, banks are spending huge sums on workout costs such as legal fees, appraisals, real estate taxes and workout personnel. The point? While near term NIMs are compressing, we think the earnings power of the banks will materialize quickly if and when the economy returns to growth.
Hope springs (ha) eternal.
David Rosenberg on why the yield curve will flatten – this time! – FT Alphaville
Yield curve can’t drive profits if banks won’t lend – Rolfe Winkler
One reason to actually worry about a flat yield curve – Atlanta Fed’s macroblog (2006)