Why Are Bank Net Interest Margins Under Pressure?

Industry analysts are beating the drum of net interest margin (NIM) decline. Irrational pricing by competitors is often cited in strategy sessions.

But in picking through the numbers, there appears to be something else at work. Factually, NIMs were actually greater in 2013 than in 2007 for Bank and Thrifts, according to the financial institutions included in SNL Financial's Bank & Thrift Index (2.91% in 2007 versus 2.94% in 2013). But NIM has been on the decline since 2010 when it stood at 3.31%.

Is it irrational pricing by the competition? I think all bankers will attest that at the forefront of the financial crisis, credit spreads worked their way back into pricing decisions. Banks were not only more cautious about the quality of the credit, but the yield on the loan too. And this partially explains why the NIM rose from 2007-2010. But has irrational loan pricing driven the NIM south since that time? The below chart shows differently.

                        Source: The Kafafian Group, Inc.

The largest loan categories on bank balance sheets actually showed spread gains during this period, until they finally began to wane in 2013.  This analysis measures loan spreads by taking the actual yield of the loan portfolios, and charging a transfer price for funding the loans using a market instrument with the same repricing characteristics. In plain English, it removes interest rate risk from the spread, often called co-terminous spread. 

How do we explain rising loan spreads, combined with decreasing NIMs? Well one reason can be the reduced benefit of deposit repricing. Financial institutions have benefited by the significantly reduced funding costs brought about by the historically low Fed Funds rate. But that benefit has been mostly exhausted. Leaving re-pricing of loans to be offset by, well, nothing.

The second culprit behind NIM decline since 2010 is the continued decline in loan to deposit ratios (see chart). Perhaps you hear talk of this in your FIs senior management meetings over the last couple of years. "We don't need more deposits because we have no place to put them." "We have tons of cash to lend." Etc.

But loan pipelines are getting fuller as the tortoise-like economic recovery grows deeper roots. With many FIs still mopping up excess liquidity, competition remains strong for those "good" credits, whatever that means. Presumably it means borrowers who will pay you back. This will continue to put pressure on NIMs. Once rates rise, there will likely be additional pressures as the least liquid FIs start pricing up their deposits to keep funding their pipeline. 

Will deposit rates rise faster than the loans those deposits will fund? Time will tell. 

Do you think NIMs will continue to decline, even when rates rise?

~ Jeff

Uncle Sam: Get out of my house!

Freddie Mac posted a $4.5 billion fourth quarter profit. Fannie Mae did not yet report but made $1.8 billion in the third quarter. So our Government Sponsored Enterprises (GSEs) are minting over $25 billion to their owners... Uncle Sam. Folks, revenue to the government is like crack. Congress won't be taking up GSE reform anytime soon.

This poses a challenge for bankers. Twenty five percent of our loans are in residential mortgages (see chart). Eighty percent of mortgage originations currently pass through the GSEs. In other words, Uncle Sam owns the mortgage market and dictates its terms. Ever heard of a QM (qualified mortgage)? I would not call myself a libertarian because there are legitimate reasons for the government to participate in free markets. When the payoff is long term, such as drug research, comes to mind.

But residential mortgages are not the same as the cure for pleuropulmonary blastoma. The market is fairly mature. FHFA (regulator for the GSEs) Director Edward DeMarco recognizes this and is working on developing a sustainable mortgage trading platform that can eventually be in private hands. Mortgages can be done by banks, credit unions, and the shadow banking system, without Uncle Sam's assistance.

If you believe what I say is true, and perhaps our Congress finds religion to make it so, there will be changes. Some of these changes will not benefit consumers in the short term. Mainly, we are likely to see a decline in the number of 30-year mortgages.

Now, I have a 30-year mortgage. Who wouldn't with rates so low? But, truth be told, there is no way a financial institution (FI) can find 30-year funding. I understand that the "average" mortgage loan lasts seven or eight years because people move. And that there is some cash flow to the FI because the loan amortizes. But there is no seven year funding FIs can tap either. 

If the mortgage market became more private, the 5-1 or 7-1 ARM would assume a higher perch. This is more palatable to FI risk managers and would allow for them to put more of these loans on their books. If booking the loans, they don't have to worry about the tail risk and all of the other bad things that can happen as a result of government intervention and QMs.

I don't believe 30-year mortgages would go away. Their would still be a secondary market with private investors to purchase pools of mortgages. Additionally, FIs may determine to book some 30-years, and to accept the interest rate risk or hedge it. But the 30-year will begin to be priced to market, instead of artificially low because of all the government interference.

The end result will be a resurgence of local FIs willing to lend and book their customers residential mortgages. There will be more choices for borrowers. And yes, borrowers will more frequently have to accept interest rate resets sooner than 30 years out.

How do you think FIs can more fully participate in residential mortgage lending?

~ Jeff