The good, the bad and the unknown in Fed's latest rate hike

The Federal Reserve recently approved its third interest rate increase of the year, and that is both good and concerning news for banks.

On the plus side, higher rates typically mean improved yields on loans. Commercial and consumer loans should both benefit from higher interest rates, though the timing of the impact could be delayed, depending on specific floating-rate loans’ repricing schedules.

On the negative side, higher rates put added pressure to pay more to depositors on money markets, certificates of deposit and savings accounts, potentially squeezing net interest margins. Rising rates also tend to dampen mortgage-refinance volumes.

Then there are the unknowns, such as the impact a rising rate environment could have on mergers and acquisitions. Here’s a look at how rising rates could affect banks’ decision-making, and bottom lines.

A tipping point on deposit rates?
The biggest banks have largely delayed paying higher rates on consumer deposits, and in doing so they have kept their cost of funding loans relatively low. Bank of America, for example, is paying just 0.07% on a 12-month CD in some Atlanta-area branches.

But don’t expect the megabanks to hold out much longer.

These institutions have been waiting for the Federal Reserve to raise rates enough to create an adequate spread between what they receive from interest-bearing assets like loans and what they pay out on deposits. That probably happened when the Fed raised its benchmark interest rate by 25 basis points Sept. 26, according to Marty Mosby, an analyst at Vining Sparks.

Executives at the largest banks have given strong indications in recent months that a certain trigger might soon happen that would allow them to raise rates on savings accounts, money markets and certificates of deposit.

“Clearly, our expectation is that those retail deposit betas will be increasing in the second half of the year,” John Gerspach, the chief financial officer at Citigroup, said on Sept. 12 at an industry conference. Deposit betas are the banking industry’s method of measuring the rate of deposit cost increases.

For many depositors who have suffered through years of getting virtually no interest on their savings accounts and CDs, the prospect of all banks paying higher rates is certainly welcome news.
Higher yields on CRE loans...
Many banks should soon start to see material improvement to net interest margins from the rate hikes.

Sandler O’Neill analysts Aaron James Deer and Tim O’Brien predict the banks they follow will report a median net interest margin of 3.65% for the third quarter, up 3 basis points from the second quarter.
Banks with large portfolios of floating-rate loans can expect margins to widen even more meaningfully.

Deer highlighted the $31 billion-asset Sterling Bancorp in Montebello, N.Y., as an example of a bank that is benefiting from rising rates. About 44% of Sterling’s loan book is in commercial real estate loans, including multifamily loans, most of which have variable rates. Its net interest margin increased by 21 basis points in the 12-month period that ended June 30 — even as funding costs climbed — thanks to a 41-basis-point jump in its loan yields, according to Federal Deposit Insurance Corp. data.

Sterling’s “loan book has such rapid resets that asset yields should nearly keep pace and minimize pressure on the margin, even if interest rates continue to tick higher,” Deer wrote in an Oct. 1 research note.
...But beware of early payoffs
For every incremental improvement in loan yields, it seems banks get hit equally hard by commercial borrowers paying off their loans early.

Numerous banks have complained in recent quarters that commercial real estate investors are paying down loan balances at an accelerated rate or paying off loans entirely. The reason is that they’re flush with cash and worried about paying higher interest as the rates reset on their floating-rate loans.

Rising rates will only exacerbate this trend. Corporate and commercial real estate borrowers know that interest rates are almost certain to rise. If they are in a loan that carries a floating rate that they know will soon reprice, many will ask their lenders to renegotiate a fixed rate so they can lock in rates at current levels.

If their lender won’t oblige, borrowers will bolt to another lender who will accommodate their request.

Several banks reported flat or slight declines in CRE loan books from the first quarter to the second quarter this year, including Comerica, First Horizon National and PacWest Bancorp.

As long as the Fed keeps raising rates, it will prompt borrowers to look for better terms elsewhere. Or they may ask their lenders to refinance their loans. Some bankers may decide it’s better to refinance at terms less beneficial to the bank, rather than lose the customer, said Jeremy Starkey, head of commercial real estate finance at the $10.8 billion-asset TowneBank in Portsmouth, Va.
Keep an eye on consumer debt levels
The economy is humming and delinquency rates on auto loans and credit cards have been improving. But the Fed’s 25 basis-point rate hike will lead to higher rates on consumer loans, making it harder for some borrowers who might already be stretched thin to make their monthly loan payments.

Fewer U.S. consumers were late on credit card payments in the second quarter, according to a new American Bankers Association report, and a September report from Experian showed that auto loan credit quality appeared to be stabilizing.

The number of credit card customers who were at least 30 days overdue dropped to 2.93% in the second quarter, compared to 3.06% in the first quarter, according to the ABA. Meanwhile, banks’ car loans and leases that were at least 30 days late dropped 11 basis points to 1.88% from June 30, 2017, to June 30, 2018, Experian said.

Still, there is concern that higher rates, along with consumer debt levels reaching historic highs, are producing a consumer debt bubble. John Thompson, chief program officer at the Center for Financial Services Innovation, said recently that, just as in the run-up to the financial crisis, he is seeing many households rack up credit card debt to meet their expenses.

But the ABA’s chief economist, James Chessen, said that for now, most signs look positive.

“Overall, consumer financial health has been excellent. Jobs are plentiful, wages are rising, and savings rates have held steady at elevated levels, which paints a vivid picture conducive to low delinquencies,” Chessen said in the ABA’s Oct. 4 report on consumer delinquencies.
Mortgage lending: Quality over quantity
As rates rise, homeowners who already locked in ultralow interest rates are loathe to refinance at higher rates.

That’s a big reason why mortgage lending has slowed in recent quarters, forcing some banks to close mortgage offices and lay off staff. JPMorgan Chase said this month that it will fire 400 workers in its mortgage unit due to slack demand.

Overall origination volumes have also lagged. Fannie Mae this summer cut its 2018 origination forecast for the fourth time this year, due to rising rates.

However, many banks remain committed to the mortgage sector, and some have increased their exposure. Citizens Financial Group this summer agreed to pay $511 million to acquire Franklin American Mortgage to increase its mortgage-servicing business.

Other banks have said they can accept lower mortgage demand as long as the quality of the loans they originate remain high.

“Home lending is a very, very, very rate-driven market and we are seeing the breaking effect of higher rates,” Marianne Lake, the chief financial officer at JPMorgan Chase, said on Sept. 13 at the Barclays Global Financial Services Conference. “The market is expected to be down about 10% year on year, and we will largely be down in line with that. But, more importantly, on the mortgage front, quality is really good — really, really good.”
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If loan demand cools, look for more M&A
A big unknown is whether rising rates might weaken demand for construction lending or commercial and industrial lending.

If loan demand cools, it could prompt executives at smaller banks to explore a sale, under the assumption that they’re going to have a harder time making new loans. In many loan categories, particularly commercial and industrial lending, the expected surge in demand due to the corporate income tax cut still has not materialized.

Gerry Cuddy, CEO of Beneficial Bancorp in Philadelphia, recently said that the $5.7 billion-asset bank has seen loan demand fall as a number of large infrastructure projects in the Philly area are winding down. Cuddy speculated that it may lead some bank executives to consider finding merger partners “if they don’t think they can get the growth and the shareholder returns.”

Still, banks like PNC Financial Services Group have said their C&I loan pipelines are healthy.

“For the first time in a while, our pipelines look pretty good in C&I,” Chairman and CEO William Demchak said at an industry conference on Sept. 12.