Updated to reflect Federal Reserve QE3 announcement
NEW YORK ( TheStreet) -- Investors in the largest U.S. banks should prepare for Federal Reserve policies to turn decidedly against their favor, regardless of Thursday's announcement that the central bank will begin a third easing effort by buying $40 billion in mortgage bonds a month for the foreseeable future.
That's because the Fed's near zero interest rate policy -- now expected to continue until at least mid-2015 -- is likely to swing sharply from a bank sector earnings subsidy to a substantial hit in coming quarters.
After years of analyst warnings, net interest income, the positive difference a bank earns by extending loans and funding them with deposits will fall at an increasing rate in coming quarters, cutting interest-based earnings that count for between 40% and 70% of revenue at America's largest banks.Recently, top performing banks like Wells Fargo (WFC - Get Report) have warned of a fall in interest earnings in forecasts. Meanwhile, as the issue emerges more clearly in coming quarters, Jim Sinegal, a large cap bank equity analyst at Morningstar, says it "might even be the biggest factor to what normalized bank earnings are," as investors continue to wait for a sector-wide earnings recovery. While the Fed has pushed interest rates and U.S. Treasury bond yields to record low levels, the negative impact of those policies on interest-based bank earnings has been muted by one-time factors that are running dry. As banks enter 2013, there will be less cushion against the earnings drain. In fact, the longer the Fed keeps rates low, the worse the problem is likely to get. The good news for investors is a proper understanding of interest rate dynamics on earnings will help to discriminate between the banks that see the biggest hit and those that are in a position of strength, as the sector heads into a murky 2013. Net interest income is likely to create clear earnings contrasts between players like Wells Fargo (WFC - Get Report), JPMorgan (JPM - Get Report) and Bank of America (BAC - Get Report) -- whose earnings could suffer - as Citigroup (C - Get Report), Capital One (COF - Get Report), US Bancorp (USB - Get Report) and Discover Financial Services (DFS - Get Report) come out relatively unscathed. Four years into the crisis and Fed easing, net interest income has largely been a boogeyman for bank earnings even if logic implies that record low interest rates should already be a problem. For instance, as rates fall sharply, it was correct to assume banks would get less interest earnings on their loans and holdings of corporate bonds and Treasuries. But while yields on those of interest earning assets have fallen at or near record lows, the net revenue banks have earned is up sharply from pre-crisis years when rates were much higher. The reason is while interest earnings have fallen by up to 50% since the Fed stepped in, the cost to fund those assets - interest expense - has dropped at an even greater rate. For banking giants like JPMorgan, Bank of America and Wells Fargo, faster falling interest costs than earnings mean net interest income actually more than doubled in some cases
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