The Fed's Extension of Twist Is Bad News for U.S. Bancorp, Peers
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The Federal Reserve is at it again. It is ignoring the law of diminishing returns that inherently follows from a string of “pro-growth” policies. Mortgage rates, car loan rates, and Treasury bond rates are all at historic lows. Short term rates are approaching zero. So, the Federal Reserve is going to extend its twist program for another go round, sell short and medium term notes, and use the proceeds to buy up longer term bonds. The move, designed to lower long term rates, will cost $267 billion, and will come on the heels of an identical, $400 billion plan. In total, what we have is a Federal Reserve so clueless as to have spent $2.3 trillion the past couple years on so called “quantitative easing”, with zero evidence that the practice has been particularly effective. Despite the best of intentions, I believe the Fed is doing more harm than good.
It was no less than Albert Einstein who defined insanity as repeating the same action, and expecting a different result. So, if a larger twist operation results in a sum of only 146,000 jobs being created in April and May of this year, less than half of what most consider a healthy amount, what makes anyone think a smaller investment in the same program will do any better. I am befuddled, and see more downside than upside in the Federal Reserve action. There comes a time when longer term rates are so low for so long, that banks simply cannot afford to continue to extend credit.
No company better exemplifies the risks of another twist program than the venerable Hudson City Bancorp (NASDAQ: HCBK) You see, in the past year, not only has the Fed guaranteed depressed long term interest rates, consumer banks have also dealt with the Durbin Amendment limiting debit card fees, overdraft limitations, increased oversight from regulators, and the costs attendant to that. The bulk of that oversight is directed at banks with over $50 billion in assets, a level Hudson City was well above as recently as 2010. But management has taken the asset level down by about $16 billion, or 26%, during 2011. The reason? The bank's management does not believe it could make sufficient money in the current interest rate environment.
In the fourth quarter of last year, Hudson City retired over $4 billion in “high cost” debt. The average interest in the indebtedness was 4.21%. Only in a world where short term rates are near zero would anyone characterize long term, 4.21% bond debt as “high cost.” Hudson City management intends to get back into the mortgage underwriting business when the interest rate curve normalizes. But when will that be? In the interim, the bank will be posting earnings of about $0.15 cents per quarter, all the while slowly shrinking its balance sheet. At the height of the recession in 2008 and 2009, this bank, which never did interest-only loans, always had tough underwriting standards, and never had to post the level of charge-offs that many others did, managed to earn $0.25 to $0.30 per quarter.
A quick look at the banking landscape shows that further quantitative easing, if successful in bringing down long term interest rates, could have disastrous results for many banks. One smaller bank of interest is Bank of Hawaii (NYSE: BOH). It passes all of my standards for a well-run bank, with a return on assets in the first quarter of 1.29% and an efficiency ratio of 58.3%. Earnings in the first quarter of 2012 were up 8% from the same period of 2011 to $0.95 per share. Its main source of funds, deposits, cost it $3.47 million in the first quarter, compared to $5.2 million a year earlier. Interest and fees on loans totaled $64.7 in the first quarter, down about 3% from the first quarter of 2011. There just is not much room at all for credit costs to fall. But there is plenty of room for interest revenue to continue to fall. Bank of Hawaii has substantial investment holdings that tend to even out its earnings, but the point is easy to see.
Looking at a larger bank, U.S. Bancorp (NYSE: USB) also has sterling numbers, with a first quarter efficiency ratio of 51.9%, and a 1.60% return on assets. The overall interest expense on interest-bearing liabilities in the quarter was $599 million, with an average interest rate of 1.07%. A year ago, the credit costs were $650 million, and the average interest rate was 1.18%. There really is not a lot of downside potential there. But, like BOH, there is plenty of downside available on the interest revenue side. In the first quarter of 2012, interest revenue totaled $3.29 billion, for an average interest rate of 4.40%. A year earlier, the peer-leading bank had interest revenue of $3.16 billion, for an average interest rate of 4.65%. Any decline in interest rates will do more to hurt than to help a well-run bank like this one.
Taking one more stop up the scale of successful banks, we end with Wells Fargo (NYSE: WFC), the fourth largest bank in the country by assets with $1.33 trillion as of March 31, 2012. It had its typically successful first quarter, with a return on assets of 1.31%, and an efficiency rate of 60.1%. The bank has a cost cutting plan in place that should drive that efficiency rate down going forward.
In the first quarter of 2012, Wells Fargo's interest expense fell 25% from the first quarter of 2011 to $1.37 billion. Its interest income fell by 2% from the year earlier quarter, to $12.26 billion. In terms of yields, the average interest in its income producing portfolio fell from 4.73% in the first quarter of 2011 to 4.39% in the just concluded quarter. Credit cost average interest rates fell from 0.68 percent in the first quarter of 2011, to 0.48% in the first quarter of 2012. How much lower can credit costs possibly go? And if longer term interest rates continue to slide, the impact on Wells Fargo will be significant.
The danger is not just earnings setbacks. In fact, earnings in the current quarter will be bolstered by mortgage refinancings in the declining interest rate environment. But might interest rates go so low, that it is just not worth the effort to write mortgage loans? Stay tuned.
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