Plunging short-term interest rates were a boon to banks; declining long-term interest rates probably won't hurt.
The Fed-engineered drop in short-term interest rates since 1989 has provided banks with a cushion to recover from the collapse of the commercial real estate market in the late 1980s.
The recent drop in yields on long-term government securities is more of a mixed bag.
For banks heavily involved in mortgage banking - such as Fleet, Norwest, and First Union - the decline in long-term rates puts pressure on the net yield of mortgage portfolios. Fixed-rate mortgage rates are tied to long-term Treasury yields.
But the decline in mortgage rates is offset partially by increased loan volume, which boosts origination and servicing revenues. Since the new loans are booked at low rates, they are unlikely to be refinanced soon.
Pain and Gain
"There may be some short term pain, but there may be long-term gain if you're an effective competitor," said Lee Irving, treasurer at Keycorp.
The rate drop also means banks will get lower yields on their investment in new Treasury offerings.
However, while yields on new offerings are falling, the value of existing bond holdings is rising.
Thus, banks are adding to their storehouses of potential capital gains.
In addition, in the market-value accounting environment that begins for some institutions at yearend, banks will be able book the appreciation in their bond holdings as capital. Previously, the gain could only be booked if the bond was sold.
Shorter Maturities Preferred
Further, banks generally shy away from investing in 30-year Treasuries, the maturity whose yield has dropped most sharply in the past month. Instead, banks tend to invest in three-year to five-year securities, whose yields have dropped less sharply than that of the long bond.
The yield on the 30-year Treasury has lost about 60 basis points in the past month. The yield on the three-year note has fallen by about half that amount.
"The long end is not a big determinant of bank earnings," said John Leonard, an analyst at Salomon Brothers Inc.
Mr. Irving of Keycorp noted that the average life of his bank's investment portfolio is three years.
Moreover, lower long-term interest rates are good for borrowers - and this should enable banks asset quality to continue to improve.
"On balance, this drop in long-term interest rates has been slightly beneficial," said Irwin Kellner, chief economist at Chemical Bank.
But slightly beneficial could turn sharply negative if the drop in interest rates is symptomatic of the onset of a new recession, Mr. Kellner said.
Market analysts doubt a new recession looms, despite the unexpectedly grim employment report released last Friday. The Labor Department reported that nonfarm payrolls contracted by 39,000 in August.
Gary Schlossberg, economist at Wells Fargo & Co., noted that investors may, have overreacted to the drop in payrolls and overlooked a rise in average hours worked.
"The economy is not gathering a lot of momentum," he said. "But the drop in interest rates represents an adjustment to a lower-inflation environment."
Fed Unlikely to Tighten
Thus, a Federal Reserve tightening of credit - another factor that could turn the drop in long-term interest rates into a negative event for banks - seems out of the question for now. If inflation is low, there is no reason to tighten.
"While the next major move in interest rates is likely to be a tightening, I don't expect that to occur until well into 1994 unless there is a major change in the economic numbers." Mr. Schlossberg said.
Sung Won Sohn, chief economist at Norwest Corp., said lower long-term interest rates, combined with stable short-term rates, will encourage banks to lend more money.
"When the spread between long-term interest rates and the federal funds rate is high, banks have less incentive to make loans." he said. "The spread is now narrowing."
A Shift to Treasuries
In addition, he said, the decline in long-term rates is causing banks to shift assets from prepaying mortgage securities into Treasuries.
"In the past, a lion's share of banks' portfolios was in mortgage-backed and asset-backed securities." he said.
Meanwhile, the drop in long-term rates continued on Wednesday. At 4 p.m., the yield on the 30-year Treasury was at 5.87%, down from 5.89% on Tuesday.
