Over the last three months, interest rates have been pushed up steadily by the Fed. Key rates, like the federal funds rate and the prime rate, have increased 125 to 150 basis points. Other rates have increased in varying degrees.

How does this affect the profitability of banks and thrifts? Although the answer to this question depends on a host of individual factors, we can note some general trends.

First, banks and thrifts are affected somewhat differently by rising interest rates. While the two have become more alike over the past several years, there still remain critical differences in their revenue sources.

Thrifts, by nature, continue to be heavily oriented toward residential mortgage products. Some, of course, have branched out into consumer and commercial lending but their balance sheets remain dominated by one- to four-family residential loans and securities backed by pools of mortgages.

As mortgage rates have risen, thrifts' main business activity has slowed, decreasing asset generation and fee income. Existing fixed-rate mortgages become less valuable as the deposit funding costs increase. Adjustable-rate mortgages take time to reprice to market rates, especially if they were booked at artificially low "teaser" rates.

Banks, on the other hand, have more diversified revenue sources. The majority have a substantial portion of their balance sheet in commercial loans. Most commercial loans are variable rate and can immediately reprice as the prime rate rises.

Additionally, most banks have some volume of fixed-rate consumer loans. Very important, banks have a more developed noninterest income base. Many of these fee-based services are not rate sensitive.

Banks' earnings are, in general, less susceptible to rising interest rates than thrift earnings. This fundamental difference between banks and thrifts was evidenced by first-quarter earnings numbers.

Banks performed better than thrifts. Returns on average assets for Midwest thrifts declined to an average of 0.89% in the first quarter from 0.94% in the fourth quarter of 1993.

The average ROA for banks, meanwhile, increased from 1.11% to 1.15% in the first quarter. Thus, the ROA differential between banks and thrifts increased from 17 to 26 basis points in the first three months of 1994. This trend should be even more apparent in second-quarter earnings reports.

The earnings differences have already started to be reflected in stock prices. Our universe of 99 banks showed a median increase of 3.23% in the first quarter, versus a 1.15% median increase in our 125 thrifts.

A number of thrifts, of course, remain good buys, for a variety of reasons. Some have positioned themselves to be less susceptible to rising interest rates through diversifying their revenue streams and broadening their product base. Others enjoy strong management in good markets where housing continues to be sold and constructed.

This article was excerpted from the June issue of Howe Barnes' Monthly Bank and Thrift Report.

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