Morgan cuts prime, spurring bank selloff.

NEW YORK - Morgan Guaranty Trust Co. unexpectedly cut its prime lending rate by half a percentage point Monday, accelerating a selloff of bank stocks by investors worried that the industry's unusually large profit margins are starting to shrink.

The only bank to follow Morgan's lead was Harris Bankcorp Inc., which also cut its prime rate to 5.5%. But analysts said they except others to fall in line soon.

That prospect hammered bank stocks, which fell for the third day in a row.

The American Banker Index of 225 bank stocks dropped 2.6% on the day, versus a 0.3% increase in the Dow Jones industrial average. That brought the three-day bank declined to 5.3%.

"This is the end of the bull market" for bank stocks, said Thomas Brown, an analyst an analyst at Donaldson, Lufkin & Jenrette Securities Co.

Morgan's cut surprised analysts, both in its timing and size. Most analysts thought a 25-basis-point reduction, to 5.75%, would have been more likely.

"My assumption is that the other banks will follow suit and go down by 50 basis points," said Mr. Brown.

Analysts Dispute Morgan

A Morgan spokesman said the bank acted because it saw some growth in loan demand, with little inflation, and because the spread between the fed funds rate and the prime rate - at three percentage points - was historically high.

Analysts discounted that explanation.

"Either Morgan decided to put competitive pressure on other banks because they don't have prime-based loans, or there was political pressure on them," said Mark Alpert, an analyst at Bear, Stearns & Co.

Investors have been worried for months that the wide net interest margins that are driving bank earnings will tighten. Some signs of tightening were seen in third-quarter earnings reports last week. The cut in the prime rate plays directly into those worries.

Bank stocks have been in a bull market since Nov. 1, 1990, when the Federal Reserve reduced its target for the federal funds rate to 7.25%, widening the gap with the prime. Since then, that spread has widened from roughly 190 basis points to 300 basis points, an historic high.

That wide spread between what banks pay for funds and what they receive from borrowers has helped them rebound from bad loans to post record profits.

A narrowing was signaled last month when four banks, including Chicago-based Harris, cut their prime rates by a quarter point, to 5.75%.

Eight of the top 10 bank stocks lost more than $1 a share Monday. Banc One Corp. dropped $1.875 a share, to $40.25. Citicorp was off $1.75, to $35.625. Smaller banks were hit harder. First Interstate's share price dropped $3.25, to $60.75. First Chicago's shares plunged $2, to $45.875.

Selloff Responds to Rate Cut

While bank shares have been sinking since banks began reporting their third-quarter earnings last week, analysts and money managers said Monday's selloff was purely a reaction to the prime rate cut.

Many analysts consider that Monday's bank stock trading suffered from an overreaction. "To take 4% or 5% out of these stocks is silly," said Robert Albertson of Goldman, Sachs & Co.

Indeed, J.P. Morgan's shares were off $1.625, to $74.25, even though it has less than 3% of its loans linked to the prime rate. Analysts argued that Morgan's earnings would not be affected by its prime rate. Even Republic New York Bancorp's shares fell $2, to $50, and the bank makes few loans of any type.

How deeply a prime rate cut will affect net income is hard to say and varies by bank. Keefe, Bruyette & Woods Inc. estimated that bank profits would be 3% to 5% less than expected in 1994.

"Everything else being equal, our earnings estimates will have to be lowered," said Mr. Brown of Donaldson Lufkin. He added that, if other banks cut their rates, the earnings impact would vary from bank to bank.

For starters, other money-center banks have 10% to 15% of their loans tied to the prime, a relatively small share, according to Mr. Albertson. Regionals have about 30% of their loans tied to the prime because of their credit card businesses.

The banks most likely to suffer the most from reducing their prime rates fall into two categories.

First are those banks with large proportions of consumer loans that are funded by consumer deposits. NBD Bancorp. is an example, said analysts.

Second are those banks with a high proportion of assets in securities, particularly where those securities have a high yield and a short maturity. These are less likely to be rolled over into assets with comparable yields.

Analysts said that banks are likely to have off-balance-sheet hedges to protect their net interest margins.

Mr. Albertson said a general rate cut would have a limited effect on earnings. "Most banks have swap agreements to offset a narrowing of the fed funds to prime rate," he said.

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