Net Interest Margins etc.

I mentioned recently that what I fear most for U.S. banks is what happened in Japan; low interest rates for a long time.  If long term interest rates keep going lower, this will put pressure on bank net interest margins and therefore profits.

So I decided to take a quick look at this and found something interesting.   People used to use yield spreads as a proxy for bank profit margins.  The ones that you would hear about were the 10 year treasury rates versus 2 year rates or Fed Funds rate or some such thing.  When that was wide, bank margins were wide and vice versa.

Anyway, the following are just some thoughts.  Don't read this if you want answers.  I have no idea, frankly, if the U.S. will follow Japan; I have no idea how long interest rates will stay low.  I do actually have a hunch that it will stay low for a lot longer than most people think, though, but that doesn't mean I think we are in for a Japan scenario.

And keep in mind, I am not predicting a Japan scenario here.  It is my personal, primary risk scenario, not the base-case scenario.  My base-case scenario, perhaps naively, is that we just muddle along and do OK.  Other risk scenarios are of spiking interest rates and hyper-inflation.  I tend to lean more towards the deflationary collapse risk side than the hyper-inflation side.

In any case, I don't know which we will see if any.  This post will not try to answer that question, nor will this try to figure out if WFC and other banks are good buys here or not.  I just wanted to take a closer look at the moving parts, that's all.   Think of it as a meditation on NIM, or whatever...

Yield Curve Spread
Anyway, since NIM is my primary concern,  naturally, the first thing I should look at is the yield curve spread.  Here's a long term and shorter term chart of both yield spreads:

Yield Curve Spread

(10 yr versus FF rate and 10 yr versus 2 yr, annual data)

This is the two spreads going back to 1985.  Any further back may not be as important due to Reg Q (regulated interest rates) etc.   This chart goes to the end of 2011.  So despite very low long term rates, as of the end of 2011, spreads were still at the *upper* end of the range since the 1980s.  Of course, that's due to the very low short term interest rates.   As of the end of 2011, you can safely say that the low interest rates on the short end of the curve has been very beneficial to banks.

Here's the same data on a monthly basis since 2000 and through the end of May:

Yield Curve Spread

(10 yr versus FF rate and 10 yr versus 2 yr, monthly data)

So even including the recent plunge in long term rates, the spread is still just about in the middle of the range; the spread is not abnormally low at all.  1.8% is the end of May figure (actually, average for the month of May) for the 10 year treasury rate, and as of now that's 1.62%.

So far, even though long term interest rates have come down to abnormally low levels, thanks to the super-low short end, spreads are still within 'normal' range.

That's good news; despite declining long term rates, the yield curve is still positively sloping enough to be 'normal'.

Yield Curve Spread and NIM
So how does the above compare to bank NIMs?    Here is some annual data for Wells Fargo (WFC) going back to 1998 or so.  I plotted the NIM against the 10-2 Treasury yield spread.

Wells Fargo NIM vs. 10-2 spread

So here again is good news and then bad news.  The good news is that WFC's NIM doesn't seem too correlated to the spread.  That is due to various factors; asset-liability management, the maturity of loans (so don't reprice immediately etc).   The yield curve flattened in 2000 and 2005-2007, but WFC seemed to maintain their NIM.  That's the good news.

The bad news is that NIM has been trending down over time regardless of the spread.

Here is the NIM for all banks from a FED website.  It's the quarterly NIM for all banks.  This too, shows a steadily declining trend in NIM regardless of the yield curve.

This is from an FDIC study on net interest margins and yield curve spread back in 2006.  They do note the decline in correlation between bank NIMs and the yield curve:

Just for reference, here's the 10-year yield:

10-Year Treasury Yield (annual averages)

So What Does That Mean?

Since the yield curve spread isn't helping us see what's going on with NIM, let's take a look at the actual components.

First, we'll look at the asset side of the balance sheet. 

Yield on Interest Earning Assets at WFC versus 10-year Treasury Yield

 Since 1998, the 10 year Treasury yield has declined from 5.26% to 2.78% and the yield on earning assets at WFC declined from 8.97% to 4.55%.

WFC Funding Cost versus FF Rate 

On the liability side, WFC's funding cost has fluctuated above and below the FF rate.  Overall, during this period, funding cost has declined from 3.34% to 0.61%.

So the yield on earning assets declined 4.4% while funding cost only declined 2.73% for a spread compression of 1.67%.  There is our 1.6% NIM compression from 5.5% to 4% or so (well, that's kind of obvious in a declining interest rate environment; no charts needed to tell us that!).

It seems like banks are not correlated at all to the yield curve spread, but are now just correlated to long term interest rates.  That can't be good news in this environment.

But let's take a close look at the asset side to see how much of the NIM compression or decline in yield is due to a lower treasury rate and how much due to tighter loan spreads.

Below is the chart that shows the difference between the yield on earning assets spread versus the 10-year treasury rate:

WFC Yield on Earning Assets minus 10-year Treasury Rate

From here, we can see that a lot of the decline is due to a decline in the spread.

WFC yield on earning assets went from 8.97% in 1998 to 4.55% in 2011, a decline of 4.42%.  The ten year treasury rate went from 5.25% to 2.78% during that time (annual averages) for a decline of 2.48%, so 56% of the decline in yield is due to lower interest rates in general.  The rest comes from a decline in the above spread.

Is this due to change in mix or declining loan spreads?  As a quick proxy I just grabbed some data on rates for conventional mortgages and Moody's Baa industrial bond spreads.

Spread Versus 10-year Treasuries: Conventional Mortgages and Baa Industrial

The above chart doesn't show the whole picture, of course, but it doesn't look like spreads are at particularly low levels today than in the past (going back to 1976).

The other explanation obviously has to be asset mix.  In the above chart showing the difference between yield on earning assets and treasuries, it's interesting that the last dip occured in 2002-2003, which were weak years in the economy.   Banks tend to invest in treasuries and other securities and make less loans in a weak economic environments which may be the case now.

Asset Mix
So if the decline in yield on earning assets spread (versus 10-year treasuries) is not due to declining loan spreads, it can only be asset mix.

Here's the asset mix for WFC since 2004:

Well's Fargo's Interest Earning Assets

What I suspected was that during bad economic times, banks would make less loans and invest more in low yielding fixed income securities (like JPM's controversial $370 billion bond portfolio).  WFC management has also said during conference calls that some of the recent NIM declines were due to deposit growth outpacing their ability to make good loans; cash piles up in treasuries and other low-yielding securities decreasing yields on earning assets.

The above table does indeed show an increase in total debt securities available for sale over the past few years.   The only problem with that is that it looks like the yield on available for sale debt securities is actually higher than the total yield on all earning assets (5.21% versus 4.55% in 2011 and 6.63% versus 5.02% in 2010).   This may have something to do with a legacy portfolio from the Wachovia acquisition.

However, it is notable that consumer loans have declined from 49.44% to 38.66% from 2004 to 2011.  That's a pretty large drop, and commercial loans went up from 26% to 30%.   It looks like commercial loan yields are much lower than consumer loan yields so that would certainly be a factor in declining NIM.

I think typically the earnings asset yield is linked to the percentage of total loans to total earning assets (or total assets) as loans tend to have higher yields than securities (that banks typically buy with deposits not lent out).

Below are the figures for WFC:

Breakdown of Total Loans and AFS Debv to Total Assets

So even though yields on AFS debt has been higher than the overall yield, that hasn't always been the case; for a while, consumer loans had much higher yields than AFS debt so over time this may certainly be a factor in declining yields.

To get more color on how all of this impacts yield and NIM, I just jotted down yields on the major earning asset categories at WFC, and here it is:

Yield on Earning Assets by Major Categories (WFC)

I just put the 10-year treasury rate and spread in there for reference; of course we don't know the terms of the loans and they are most likely not 10 years, so this isn't apples to apples.

You will see that consumer loans usually have much higher spreads than the other categories.  So the declining percentage of assets going to consumer loans is a big factor (other than declining overall interest rates, which accounted for about half of the decline in yields since 1998), which makes intuitive sense.

And contrary to the spread chart above where I compared 10-year treasuries to rates on conventional mortgages and Moody's Baa Industrial bond yields, there does appear to be spread compression in WFC's book.  But this, of course, may be due to mix; they may be more selective in making loans and making only high quality loans (and therefore earning less yield).  This is consistent with what is understood to be going on in the industry.   WFC has said in conference calls that they are not seeing spread compression due to competition between lenders.

ROAA and ROAE
So how does all of this affect return on assets and return on equity?  Just out of curiosity I just jotted down the return on average assets (ROAA) and return on average equity (ROAE) of WFC since 1997.

Return on Average Assets and Equity of Wells Fargo

($billions except % and leverage (x))

I also added the ratio of total assets to shareholders equity so we can see how 'leverage' impacts ROE over time.  The argument is that banks can't be as levered as they used to be so looking at this would give us an idea on the impact of such changes in leverage going forward.

Anyway, it looks like despite low interest rates, WFC was able to earn an ROA of 1.25% versus an average since 1997 of 1.42%.  In good times WFC seems to earn ROA of 1.7-1.8% area, and this may be possible again in a stronger economy.  They are earning over 1.0% in this horrible environment so that's encouraging.

ROE at around 12% is slightly below the 15% average since 1997 and that is due to both a slight decrease in leverage and lower ROA. But again, this is in a very weak environment with housing still flat on it's back.

ROAA versus NIM

So naturally, we would want to see ROAA versus NIM to see what declining NIMs has done to it over time.  It looks like WFC was able to maintain decent ROAA despite decreasing interest rates and NIM.  

NIM is not a risk-adjusted figure, so that sort of makes sense.  When you make risky loans, NIM goes up, but so does loan losses.  If you manage the portfolio well, NIM can go down but profits can stay stable if you make better loans and write off less.  This is what I guess is happening at WFC (and other banks).  Non-interest income from fees also helps mitigate the decline in NIMs. 

If the economy starts to pick up and housing starts to move (as many people are starting to expect), then I wouldn't be surprised if WFC starts to earn over 1.5% on assets despite the interest rate environment (and interest rates may go up if housing recovers too, but it may not since global interest rates may be under pressure due to the deleveraging that still needs to take place around the world).


Conclusion
It's interesting to see that despite dramatically lower long term interest rates, the yield curve is still well within the historical range.  If rates stay down here, banks can still do OK as long as they can make decent loans.  There is nothing in the term structure of interest rates now that says banks can't do well.

However, if interest rates keep going down, then this will obviously be a problem.   This would indicate a weak economy for a longer time so loans probably won't increase too much and there may not be much opportunity to make higher yielding loans; increasing credit quality of portfolio may lead to lower and lower yields as has been the case in the past few years.

Obviously the economy would need to pick up for WFC to see loan growth and expanding interest rate margins.

It is interesting to see that NIM continued to decline even in the very strong economy of 2005-2007.  At the time, I think the argument was that irrational, non-banks and securitization markets caused loan rates to go down to unreasonable levels, but that's not really proven in the chart comparing earning asset yields to Treasuries;  the spread was fat in the good years.

In any case, WFC has shown it's ability to earn 1.7%-1.8% return on asset despite declining NIM and long term interest rates. If long term rates don't continue to decline too much and housing starts to turn, it would not be a stretch to imagine WFC doing very well.

Anyway, it looks like NIM declines are not necessarily driven by the yield curve but by lower long term interest rates.  The yield on earning assets have declined partly due to lower long term interest rates and also due to a declining spread on loans, but this seems to be due to asset mix/loan quality issues rather than declining spreads due to competition between lenders.  Much lower portion of the loan portfolio going into consumer loans is a big factor.

So anyway, we are back to what we knew in the first place;  WFC is doing pretty good in this awful environment but can do really well if housing/economy really does pick up (and if consumer loan demand goes up).   If interest rates stay down here, WFC can actually still do well, just not great. 

But if long term interest rates continue to decline and housing doesn't recover, then that will be a problem;  WFC may end up having to put more of their deposits into low yielding Treasuries and that would not be so great.  That would be like the Japan scenario, even though I would think that WFC management would respond more quickly to such a scenario and not just sit there and hope.