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TheStreet Open House

Bank Stocks' Fed 'Destruction' Will Hit Hard in 2013

Stocks in this article: WFCCBACJPMCOFDFSUSB

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) 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), JPMorgan (JPM) and Bank of America (BAC) -- whose earnings could suffer - as Citigroup (C), Capital One (COF), US Bancorp (USB) and Discover Financial Services (DFS) 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 earnings are colored by large acquisitions such as Washington Mutual, Merrill Lynch and Wachovia .

A few factors have helped.

The assets that banks earn interest on have relatively long maturities, in contrast to funding sources like deposits and short-term borrowings, which adjust quickly to changing rates. It means banks hold loans or securities carrying pre-crisis yields against post-crisis low expense. Meanwhile, banks have been redeeming high-cost borrowings, effectively refinancing at lower interest rates. But those, and other factors like the write up of acquired assets from crisis-time mergers are all running dry, as pre-crisis assets mature, refinancing opportunities diminish and writeups slow. Interest margins are already trending lower

"We are at the point now where we continue to see net interest margins under pressure," says Fred Cannon, a director of bank research at KBW.

Cannon says declining interest earnings and margin pressures are poised to accelerate in 2013, with the prospect that the Fed's maintenance of low-rates becomes a growing problem with each passing year. "Every year that you get farther and farther in this rate environment it gets harder to find offsets," he adds.

On Tuesday, Wells Fargo chief financial officer Timothy Sloan warned of the problem in a presentation at the Barclays Global Financial Services conference, highlighting that the bank's portfolio of bond securities carrying pre-crisis yields faces maturities that will push interest earnings lower. Wells Fargo now expects interest margins to fall 17 basis points and resemble year-ago levels in the third quarter.

Sloan highlighted two key factors: declining gains from the write up of credit-impaired loans acquired during the crisis Wells Fargo bought Wachovia in 2008 - and a run-off of higher-yielding debt securities.

Previously, those factors helped Wells Fargo more than double net interest earnings since 2007. While interest earnings have risen modestly as a result of the Wachovia acquisition, interest cost is off roughly 60% in the past five years. For JPMorgan, the liquidation of its 'Chief Investment Office' after a $5.8 billion trading loss may be a similar earnings hit.

"This is the reality of a low interest rate environment. Sooner or later, it catches up to you," says Nancy Bush, the head of bank research firm NAB Research. "We are at sort of coming to the point of greatest destruction over the coming year," she says.

Cannon of KBW highlights Wells Fargo as the most exposed large cap bank to the negative impact of interest rate dynamics. In contrast, he counts credit card lenders like Capital One and Discover Financial, and US Bancorp, which earns a lot of fee-based revenue, as banks that may come out relatively unscathed. If you haven't noticed, card rates aren't much changed by Fed policy .

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