Will Banks Survive the Coming Rate Squeeze?
Karen is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The historically low interest rates we’re enjoying may soon turn sour for mortgage lenders. The housing market is showing serious signs of recovery, and new home and loan refinancing applications hit a new high this past June. But a perfect financial storm may be brewing once interest rates start rising and lenders find themselves caught in an interest rate squeeze.
The Savings & Loan crisis of the 1980s had its roots in an interest rate squeeze. Home loans carried very low interest rates and had a correspondingly low profit margin. But as interest rates rose, S&Ls had to offer higher interest rates to attract depositors and the interest paid on those accounts exceeded the interest income received from mortgage payments. Could today’s low interest rates combined with increased lending be setting up the banks for a replay of the S&L demise?
Wells Fargo (NYSE: WFC) has emerged as the nation’s largest home mortgage lender; one out of every three U.S. home loans is made and funded by Wells Fargo. Forty-one percent of their entire loan portfolio is made up of residential loans worth about $312 billion. Wells Fargo is also a major corresponding lender, in which Wells Fargo buys mortgages made by smaller banks. This adds an additional layer of risk, for while Wells Fargo has stringent loan requirements, the mortgages they purchase may hold far greater risks of default or foreclosure.
Bank of America (NYSE: BAC) is the nation’s second largest originator of residential loans and the largest loan servicer. But Bank of America is still grappling with the Countrywide purchase and all of the resulting legal entanglements. Countrywide’s original loan portfolio, valued at over $424 billion, continues to weigh heavily on Bank of America’s books. When interest rates rise, Bank of America will feel the rate squeeze almost immediately.
As the third largest home loan originator, Citibank (NYSE: C) has very high operating costs that CEO Vikram Pandit is still trying to get under control. The bank had a home loan portfolio valued at $73.8 billion at the end of their first quarter 2012. Since 2004, more than 30% of loans originated through Citibank have gone into default.
The nation’s three largest lenders face tremendous exposure from rising interest rates. As an example, in the tenth year of a $100,000 30-year 3.75 fixed loan, the bank will receive yearly interest totaling $7,455. A $100,000 money market deposit account compounding for ten years at 5% will cost the bank $8,016; if interest rates rise to 7%, that amount jumps to $13,548. Multiply that by hundreds of thousands of loans and banks could face daunting losses from this interest rate squeeze.
Of course this overly simplified scenario does not take into account the income banks earn on their high interest credit card and auto loan portfolios, income which could potentially offset any mortgage loan portfolio losses. Nor does it factor in a potential run on the banks that may occur if these substantial losses come about. But interest rates are not going to stay low forever, and sooner or later banks will find themselves caught in a rate squeeze. What remains to be seen is how well prepared Wells Fargo, Bank of America and Citibank are to successfully meet this challenge.
kprogers has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , and Wells Fargo & Company and has the following options: short APR 2012 $21.00 puts on Wells Fargo & Company, short APR 2012 $29.00 calls on Wells Fargo & Company, short OCT 2012 $33.00 puts on Wells Fargo & Company, and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
