Banking on Banks Amid Higher Rates

Nathaniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Over the last couple of weeks, interest rates across the bond market have rising fairly drastically as a result of fears concerning tighter monetary policy. While at this time its not clear if the rise is justified, I have been looking for select companies that would benefit from rising rates. I've come across many financial names as you would imagine. In this article I would like to take look at Wells Fargo (NYSE: WFC) in particular. 

The mortgage king

Wells Fargo, a diversified financial company, has performed especially well so far this year in line with the broader sector. Share have moved higher by over 20% with much of this move coming in recent days. While the market has been especially turbulent this month, shares of the company has remained quiet and seemingly unphased by the speculation surrounding the future of quantitative easing. 

Why?

Well, the company can drive higher profits over the longer term with higher interest rates. It is largest mortgage banking company in the country, with 26% of its revenues originating from this business segment. As I'm sure many of you are aware, mortgage rates have been in a steady decline for the last couple of years before bottoming out at just under 3.5%.

As ten-year treasury rates spike above 2.5%, longer-dated interest rates followed along. The 30-year mortgage rate spiked above 4% earlier this month and now sits at 3.93%. Wells Fargo benefits from rising mortgage rates in two ways.

The first is that financial institutions generally watch their net interest margin rise as interest rise over the long term. Let me define net interest margin as the average yield on earning assets minus the average interest rate paid for deposits. The spread between the cost of borrowed money and the actual rates banks can charge their customers widens as interest rates rise.


Wells Fargo generates 49% of its income from interest-generating loans. Over last couple of years, as seen above, the company has watched its net interest margins decline with interest rates. As mortgage rates rise, amid stable borrowing costs, the company should see its net interest margins rise once again. The revenue it generates from its mortgage business should contribute greatly to the top line as mortgage demand has risen alongside rising rates. The housing recovery, in combination with rising credit, is opening the doors to higher lending volumes. 

Second, as interest rates rise, the percentage of mortgages paid off early actually declines. Odd, right? You would think that people would be more inclined to pay off their loans early when they are paying more in interest, but the opposite is actually true because discretionary income declines as rates rise. This allows Wells Fargo to generate more revenues per existing loans. 

Secondary plays

While Wells Fargo is my top financial sector pick, other well-known financial institutions also look promising in a rising-rate environment. Look towards credit card companies to benefit from rising rates and improving credit quality. Discover Financial Services (NYSE: DFS) and Citigroup (NYSE: C) have both reported strong financial data as of late.

Last month, average APR rates ticked up slightly while delinquency rates dropped. Discover reported a 1.58% delinquency rate for May while Citi reported 1.98%, both under the typical 3-5% deliquescent rate. Discover trades at an attractive 10 times its earnings with an analyst-estimated 9.8% earnings growth. I believe that we could also see Discover benefit from the expected jump in federal student loan rates.

Legislators have failed to extend the extremely low subsidized rates available to low-income students, and as a result the interest rates on the popular Stafford loans jumped to 6.8%. This increase puts the loans above the low end of Discover's private loan range. I would expect to see more students look to compare pricing with an industry leader like Discover before accepting their higher APR loans. Increased demand during a time a rising interest rates would bode well for the company's top and bottom lines. 

Citigroup trades at 12 times earnings with slightly lower price/earnings to growth ratio of only 1. Analysts are expecting 22% growth this year, followed by 15% growth the year after. As with Well Fargo, Citigroup's net interest margins should be helped by rising interest rates.

While the company has been weighed down over the past few years, its capital structure has improved to acceptable standards under the Tier 1 requirments. I would expect the company to consider upping its lowly dividend payout ratio from near zero. Should interest rates continue higher, expect analysts to reconsider their price targets to the upside.

Wrap-up

While the market may tumble amid rising rates, select companies are positioned well to benefit. Wells Fargo, Discover Financial Services, and Citigroup should benefit from rising net interest margins coupled with improving financial conditions. Any broad market weakness is an opportunity to start a position in the financial sector.

Many investors are terrified about investing in big banking stocks after the crash, but the sector has one notable stand-out. In a sea of mismanaged and dangerous peers, it rises above as "The Only Big Bank Built to Last." You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.

 


Nathaniel Matherson has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Citigroup Inc and Wells Fargo. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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