Who's Collecting the Most Free Money?
12/03/2010 12:48 pm EST
With banks, it’s the spread that counts. And it looks like the turmoil in the financial markets is expanding the spread between what banks have to pay for funds and what they can charge for their loans.
That should add to bank profits in the fourth quarter. If you’re looking to take advantage of that trend, look for banks with big deposit-gathering machines. My choice would be JPMorgan Chase (NYSE: JPM). The stock is already a member of my Jubak’s Picks portfolio.
Here’s how spreads work: Banks pay for funds either in the form of interest that they pay to investors who buy their short-term commercial paper and other debt or in the form of interest they pay to depositors who keep money in the bank. They then lend out that money to borrowers in the form of home mortgages, small business loans, real estate development loans, corporate loans, whatever. The difference between the price of money paid by the bank and the price of money paid by borrowers is the spread. Once you deduct the bank’s other costs of doing business, the spread becomes the bank’s profits.
Once upon a time—back before the US mortgage crisis and the global financial crisis—banks raised their funds mostly in the financial markets by selling short-term debt. Many banks had moved away from using deposits as a primary source of funds. Raising money in the debt market was easier, faster, and often cheaper.
That’s changed since the financial crisis. The short-term commercial paper market froze solid, and many banks couldn’t raise funds from this source. The commercial paper market has since started to function again, but it continues to shrink in size. The commercial paper market, which peaked in size at $2.2 trillion in 2007, totaled just $1.021 trillion for the week that ended on December 1.
Interest rates on commercial paper are now very low at 0.24% on 90-day debt. But the crisis has taught banks a lesson about the risk of this funding source. A 0.24% loan for 90-days is great—as long as you can roll over the debt into another loan at the end of those 90 days. If you can’t, that money isn’t cheap, it’s a disaster.
All of which, plus really low interest rates paid on deposits, has led to a shift by banks to using deposits for funding. Commercial banks in the United States added $88.9 billion in core deposits—checking balances, savings accounts, and CDs of less than $100,000—in the third quarter, bring their total core deposits to $6 trillion, the most stretching back to 1992, according to the Federal Deposit Insurance Corp.
The average interest paid on total core deposits is now just 0.8%, the lowest since 2000. But that’s deceptive. About two-thirds of the $88.9 billion in core deposits added in the third quarter—or almost $60 billion—don’t pay any interest at all.
They’re free money to banks.
So any bank that’s gathering core deposits right now is lowering its cost of money, increasing its spread, and adding to profits.
Not all banks are equally good at gathering deposits. Many let their deposit-gathering infrastructure decay through inattention during the heyday of the commercial paper market. And it’s hard to reverse that decay. Depositors are among the most loyal of bank customers, so attracting new depositors from other banks is hard and expensive. That’s especially true right now when bank customers seem to value safety—and that means familiarity—over interest rates. And remember that the goal is attracting free money and not just any core deposit.
During the first three quarters of the year, according to Bloomberg, JPMorgan Chase had the biggest percentage increase in deposits that don’t pay interest among the six largest US commercial banks. The increase came to 7.5%. That’s a lot of free money since JPMorgan Chase is the second largest US bank by deposits.
Among the big six, US Bancorp (NYSE: USB) showed the second-largest increase, 6.7%; PNC Financial Services (NYSE: PNC) was third with a 3.8% gain; and Wells Fargo (NYSE: WFC) came in fourth with a 1.7% increase. (US Bancorp is also a Jubak’s Picks portfolio member.)
Bank of America (NYSE: BAC) and Citigroup (NYSE: C) both showed a decline, 1.5% and 9.7%, respectively. Bank of America told Bloomberg that the drop in non-interest paying US deposits was a result of the bank’s sale of First Republic Bank, while Citigroup said that if you include foreign accounts, its total of non-interest paying deposits had increased in the first three quarters of 2010.
The ability to gather low-cost deposits is likely to become more important to banks, too. The US savings rate has soared to 5.7% of disposable income this year, up from 3.1% in the previous decade.
So this is not just a big pot of money; it’s also a growing pot of money.
No doubt there’s a lot of headline risk in any bank stock right now. There’s a crisis going on in Europe, you may have noticed, and billions in lawsuits in the US to force banks into buying back home mortgages behind securitized debt offerings that have gone bad. But I think the company’s announced wish to raise its dividend in 2011 takes much of the risk out of the stock.
As of December 3, I’m keeping my target price for JPM at $55 by June 2011. You can take some risk by buying at $37 or better.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. It did not own shares of any stock mentioned in this post as of the end of the September quarter. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund’s portfolio here.
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