American Express (AXP - Get Report) on Monday became the latest large lender to report solid-looking third-quarter earnings, which will no doubt prompt observers to marvel once again at the fundamental soundness of the American financial system despite the economic slowdown.

Investors also have been reassured by third-quarter results from Citigroup ( C - Get Report), Bank of America ( BAC - Get Report), Wells Fargo ( WFC - Get Report) and Bank One ( ONE - Get Report). But the critical reason why financial companies haven't blown up at the bottom of this business cycle isn't primarily of their own doing: Instead, an arm of the government has enabled banks to drastically cut one of their main operating expenses.

That arm is the Federal Reserve, and the expense is the cost of the money that lenders themselves borrow. By making five cuts in the federal funds rate since the third quarter of last year, the central bank under Alan Greenspan has effectively bailed out the banks by allowing them to generate billions of extra dollars in lending income. Without the large drops in interest expense, bank profits could be flat or lower, compared with the year-ago period, and balance sheets would be showing signs of stress.

Warning Warning

As a result, investors need to approach banks with caution. The ability of large financial institutions to stay on an even keel as the economy has soured says little about management's skill and almost nothing about the banks' true earnings power. It would be like buying Ford ( F) on a 50% drop in steel prices.

In fact, the easy money is a reason to be fearful of bank stocks over the long run, because the Fed's decision to cut the fed funds rate all the way to 1.75% has encouraged bankers to expand their loan portfolios to individuals in a binge that could one day cause nasty credit problems. But for the time being, banks are in favor, and their recent rally has much to do with rumors that Greenspan, seeing more economic weakness, will cut rates again at its policy meeting on Nov. 6.

The drop in interest costs has been stunning. But before looking at some hard numbers, a caveat: The interest expense figure is only one item in the income statement. Lower interest rates also mean lower revenue on the loans banks make.


Thanks, Al
Selected lenders' savings from lower borrowing costs
Lender Q3 Drop in Interest Expense* Q3 Gain in Pretax Income** Change in Interest Expense as % of Change in Income
Citigroup $2,423 $690 351%
Bank of America 1,235 1,719 72
American Express** 389 155 251
Bank One 678 85 798
Wells Fargo 611 396 154
Note: Figures in millions.
* Change measured from third quarter 2002 to third quarter 2001
** Pretax income excludes charges in third quarter of 2001
Source: Detox, company earnings statements

But generally, banks' interest costs have fallen much more than the revenue they gain from making loans. For example, at Bank One and Bank of America, third-quarter interest costs fell at twice the speed of interest income from the year-earlier period.

Helping Hand

Somehow, Citigroup's third-quarter interest expense of $5.9 billion was $2.4 billion, or 29%, below the year-ago figure. That's over three times the $690 million increase in pretax core income over the same period. Clearly, without a helping hand from the Fed, Citigroup's earnings would be a lot softer. As the table shows, only Bank of America's drop in interest expense was exceeded by the growth in pretax income.

Of course, one of the Fed's jobs is to pump liquidity into the financial system in tough times to avoid a credit crunch. But one of the unintended consequences of that policy is that banks keep on making stupid loans, as is the case with the mortgage refinancing boom right now.

When credit problems for retail borrowers surface, the market will start demanding that banks borrow at much higher rates. And that's when interest costs soar no matter what the Fed does.