Matthew Goldstein

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Commerce Tosses a Curve

Matthew Goldstein

The flattening yield curve is squashing profits at fast-growing Commerce Bancorp(CBH Quote).

The New Jersey-based lender warned Monday that the narrowing spread between short-and long-term interest rates will reduce its profits in both the third and fourth quarters.

Commerce now says third-quarter profits will come in 2 cents short of the Thomson Financial consensus estimate of 47 cents a share, and 4 cents shy of the fourth-quarter estimate of 49 cents. The bank expects to earn 45 cents a share in both quarters.

The shares tanked $2.46, or 7%, to $31.30 in the minutes after the warning hit. The tumble follows a 25% rally in the shares since June.

"The continued flattening of the yield curve over an extended period of time has had a greater negative impact on net interest income, net income and earnings per share than originally projected by management," the company said.

"When the yield curve stops flattening, income growth will be driven by deposit growth. Our long-term growth targets remain deposit growth of 25% and EPS growth of 20%," it said.

Ever since the Federal Reserve began raising interest rates a year ago, banks have been forced to deal with a flattening yield curve.

Normally, long-term rates rise when the Fed increase short-term rates. But that's not happening this time. And the narrowing spread between interest rates has made it more difficult for banks to make money off of their investments.

For the past few years, many banks feasted on the wide gap between short-term and long-term interest rates, by borrowing on the cheap and reinvesting the money in higher-yielding mortgage-backed securities. On Wall Street, this type of investing is called the carry trade, and it was a big source of income for many banks.

But the flattening yield has been the death knell for this kind of quick profit, and it poses a problem for banks heavily invested in interest-rate-sensitive securities.

"I try to avoid financial institutions that have large securities portfolios,'' says Michael Stead, the manager for River Aire Investment, a hedge fund that mainly invests in financial stocks. "It's really an extent of how much of the assets are tied up in securities. And what is the average life of those securities.''

Stead doesn't own shares of Commerce and says he has shied away from the bank because its growth has been heavily tied to its investment strategy.

The flattening yield curve also has a negative impact on a bank's lending operation, because there's less of a spread between a bank's own borrowing costs and the interest rate it can charge borrowers. A small spread diminishes the profit opportunities for a bank.

Until now, the flattening yield curve has been more of a nuisance than a big problem for the nation's banks. In the second quarter, midwestern lender Fifth Third(FITB Quote) was one of the few large banks to report a decline in earnings due to the tricky interest rate environment.

However, Commerce's warning could be harbinger of more bad news to come.