Since the 2008 economic crisis, the Federal Reserve has taken steps to reduce the volatility in interest rates in order to boost the economy and to reduce unemployment. Generally, rising bond yields suggest the economy is booming, with a higher demand for loans.
The banking industry is highly dependent on interest rates as a source of income and net interest margin is a banks’ primary driver of earnings. Therefore, rising interest rates generally point towards higher banking profits. However, that’s not the case in the U.S. right now. The rates are on the rise, but the lending activity is still sluggish.
Fed to trim quantitative easing program
The increase in yields has a potential impact on the housing market as the 30-year mortgage rates are up by 50 basis points and expected to grow to around 4% in the second half of 2013.
Due to a rise in mortgage rates, refinance originations are estimated to be lower in the second half of this year. The expectations of refinance originations are a total of about $1.1 trillion for this year, which is lower than the corresponding $1.5 trillion of last year.
The Fed has indicated it will trim quantitative easing in the near future, which means a rise in interest rates, causing a further decline in the refinance activity. To boost the economy by encouraging borrowing and spending by business and consumers, the central bank has preserved low interest rates by buying the long-term bonds and has kept the short-term rate in the range of zero to 0.25%.
Despite mounting interest rates, most banks will not benefit due to the downturn in the economy. However, a few bank executives predicted that their bank will make money from the rising interest rates.Two of the largest banks, Wells Fargo & Co (NYSE:WFC) and JPMorgan Chase & Co. (NYSE:JPM), announced they will benefit from rising returns.
Wells Fargo & Co (NYSE:WFC) is rapidly buying bonds in order to gain from higher yields on new production bonds. At the end of March, fixed income securities accounted for 21% of the assets at US lenders.
Wells Fargo & Co (NYSE:WFC) reported a fantastic first quarter result. Revenue was almost same over the year but reported a record net income of $5.17 billion. The bank increased its return on assets by 18 basis points to 1.49%. Return on assets is the best metric to analyze how well a bank uses its assets to generate net income.
Its acquisition of Wachovia in 2008 helped Wells Fargo & Co (NYSE:WFC) to become the fourth largest U.S bank in terms of total assets. Wells Fargo is a top choice of Warren Buffet’s Berkshire Hathaway due to low funding cost.
Due to the increase in 10 years yield, spread between the mortgage loan rates and yields on mortgage-backed securities contracted, which means a lower gain on sale of new originations. Mortgage banking revenue has been a significant source of income for Wells Fargo & Co (NYSE:WFC). In the preceding quarter, its mortgage originations were down to $109 billion from $125 billion in the last quarter of 2012. However, one identified risk with Wells Fargo is that rising home prices may impact its mortgage business.
JP Morgan to make $5 billion
JP Morgan CEO Jamie Dimon foresaw that JPMorgan Chase & Co. (NYSE:JPM) would make $5 billion over the following twelve months if the yield surges by 3%. JPMorgan has a price to book value and price to earnings ratio (ttm) of 1.04 and 9.61 respectively, compared to the industry average of 2.67 and 12.48 respectively. Looking at these metrics, it seems JPMorgan is cheaply valued to its peers.
In the first quarter of 2013, JPMorgan Chase & Co. (NYSE:JPM) Mortgage banking net income decreased by 31% compared to the first quarter of 2012, while margins on lending declined to 2.37% from 2.61% a year earlier.
Additionally, it’s cost cutting action will help improve its bottom line. The bank announced to cut down 4000 jobs this year to slash expenses by $1 billion. JPMorgan Chase & Co. (NYSE:JPM) is well-diversified with $2.4 trillion in assets and $1 trillion in total deposits, so it is unlikely that the bank will suffer a downturn in profitability.