Two Banks to Buy, One to Avoid

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Since the 2008 economic crisis, the Federal Reserve has taken steps to reduce the volatility in interest rates in order to boost the economy and to reduce unemployment. Generally, rising bond yields suggest the economy is booming, with a higher demand for loans.

The banking industry is highly dependent on interest rates as a source of income and net interest margin is a banks’ primary driver of earnings. Therefore, rising interest rates generally point towards higher banking profits. However, that’s not the case in the U.S. right now. The rates are on the rise, but the lending activity is still sluggish.

Fed to trim quantitative easing program

The increase in yields has a potential impact on the housing market as the 30-year mortgage rates are up by 50 basis points and expected to grow to around 4% in the second half of 2013.

Due to a rise in mortgage rates, refinance originations are estimated to be lower in the second half of this year. The expectations of refinance originations are a total of about $1.1 trillion for this year, which is lower than the corresponding $1.5 trillion of last year.

The Fed has indicated it will trim quantitative easing in the near future, which means a rise in interest rates, causing a further decline in the refinance activity. To boost the economy by encouraging borrowing and spending by business and consumers, the central bank has preserved low interest rates by buying the long-term bonds and has kept the short-term rate in the range of zero to 0.25%.

Despite mounting interest rates, most banks will not benefit due to the downturn in the economy. However, a few bank executives predicted that their bank will make money from the rising interest rates.Two of the largest banks, Wells Fargo & Company (NYSE: WFC) and JPMorgan Chase & Co. (NYSE: JPM) announced they will benefit from rising returns.

Wells Fargo is rapidly buying bonds in order to gain from higher yields on new production bonds. At the end of March, fixed income securities accounted for 21% of the assets at US lenders.

Wells Fargo reported a fantastic first quarter result. Revenue was almost same over the year but reported a record net income of $5.17 billion. The bank increased its return on assets by 18 basis points to 1.49%. Return on assets is the best metric to analyze how well a bank uses its assets to generate net income.

Its acquisition of Wachovia in 2008 helped Wells Fargo to become the fourth largest U.S bank in terms of total assets. Wells Fargo is a top choice of Warren Buffet's Berkshire Hathaway due to low funding cost.

Increasing spread

Due to the increase in 10 years yield, spread between the mortgage loan rates and yields on mortgage-backed securities contracted, which means a lower gain on sale of new originations. Mortgage banking revenue has been a significant source of income for Wells Fargo. In the preceding quarter, its mortgage originations were down to $109 billion from $125 billion in the last quarter of 2012. However, one identified risk with Wells Fargo is that rising home prices may impact its mortgage business.

JP Morgan to make $5 billion

JP Morgan CEO Jamie Dimon foresaw that JPMorgan would make $5 billion over the following twelve months if the yield surges by 3%. JPMorgan has a price to book value and price to earnings ratio (ttm) of 1.04 and 9.61 respectively, compared to the industry average of 2.67 and 12.48 respectively. Looking at these metrics, it seems JPMorgan is cheaply valued to its peers.

In the first quarter of 2013, JPMorgan Mortgage banking net income decreased by 31% compared to the first quarter of 2012, while margins on lending declined to 2.37% from 2.61% a year earlier.

Additionally, it's cost cutting action will help improve its bottom line. The bank announced to cut down 4000 jobs this year to slash expenses by $1 billion. JP Morgan is well-diversified with $2.4 trillion in assets and $1 trillion in total deposits, so it is unlikely that the bank will suffer a downturn in profitability.

Investors see the rising interest rates as a strength for Citigroup (NYSE: C). The bank generates about half of its revenue from the international presence, due to which it obtains many tax reliefs. One analyst predicted that Citigroup may face the worst transaction loss and can lose from $5 billion to $7 billion if the dollar gained against the Yen and Euro.

Citigroup will not benefit from rising interest rates unless it improves its new loan request as the bank doesn’t see its mortgages as a big business.

Citigroup is now closing its units in countries where costs are higher than income in order to save more than $1.1 billion annually. The company has agreed to sell its Uruguayan unit to Itaú Unibanco, Brazil's largest bank by market value. Uruguay's units have more than 1500 clients and $265 million in deposits.The deal also includes the transfer of the credit card portfolio developed by Citigroup in Uruguay which has a worth of $60 million.

Conclusion

Uncertainty regarding the interest rates is enormous, but the two largest banks, Wells Fargo and JP Morgan, are well managed to benefit from the rising interest rates as indicated by their CEOs. Despite a number of trading losses, JP Morgan has been able to generate solid profit, which is why I am bullish on it. Wells Fargo is financially strong and well maintained to remain the leader in the Mortgage market. Citigroup needs to improve its loan demand and try to mitigate the currency losses. Economic weakness in Europe and Asia may reduce the opportunity for Citigroup to generate profit.


Red Chip has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Citigroup Inc , JPMorgan Chase & Co., 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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