Rate Spread Is Money in the Bank

02/21/2011 12:26 pm EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

Bank of America shareholders will profit handsomely from high lending margins and the improving economy, writes Elliott Gue in Personal Finance.

For many years, successful bankers followed the 3-6-3 rule: Borrow at 3%, lend at 6%, and book tee time for 3 p.m. Some of the numbers have changed, but the basic business hasn’t: Banks still make money by borrowing at low short-term interest rates and lending at higher long-term rates.

The Federal Reserve has kept short-term interest rates at nearly 0%, two-year US government bonds yield slightly more than 0.6%, and banks are paying consumers next to nothing in interest on checking and savings accounts. Meanwhile, the 10-year Treasury note yields about 3.4%, low by historical standards but much higher than the roughly 0.6% offered by two-year notes.

In this environment, banks enjoy a healthy spread between their borrowing costs and what they charge on loans.

Gue Chart 1

Although politicians often criticize the big banks for refusing to lend, the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices demonstrates the real problem: weak demand for loans.

But the economic recovery should bolster loan volumes. Several of the nation’s largest financial institutions noted an uptick in demand for commercial and industrial loans, even among smaller companies that are more sensitive to economic conditions.

Banks Poised to Rally
This nascent trend should gain strength throughout 2011, which is good news for the sector. As you can see from the chart below, financial names tend to outperform the S&P 500 when the economy picks up and the stock market is on a run.

Gue Chart 2

Improving credit quality provides another catalyst for the group. Most of the mega-lenders have reported a steady decline in loan delinquencies and charge-offs since 2009, allowing them to reduce the amount of money set aside to cover bad debts.

Meanwhile, financial stocks in the S&P 500 sport a price-to-book ratio of 1.06%, almost half the group’s 20-year average. Compelling valuations and improving fundamentals mean that 2011 could be a strong year for shares of the biggest US banks.

Not the Best House on the Block
Bank of America (NYSE: BAC) suffered mightily during the financial crisis of 2007-09. Not only were the bank’s legacy loan portfolios hit hard by delinquencies and charge-offs, but the company also assumed additional liabilities and credit risk when it acquired Countrywide Financial and Merrill Lynch.

The firm lost money in the fourth quarter after taking a laundry list of exceptional charges, many of which stemmed from legal costs and losses related to putbacks of faulty mortgages. Over the past year, mortgage bondholders have stepped up repurchase requests on underlying loans that lack the necessary documentation or were serviced improperly.  

But bearish commentators exaggerate the risks associated with putbacks. In early January, the bank agreed to pay $2.8 billion—a fraction of what many had predicted—to settle repurchase requests from Fannie Mae and Freddie Mac. Management estimates that the bank will spend a total of $7 to $10 billion resolving putbacks.

Plenty of Cash in Reserve
Further clarity on mortgage buybacks should help investors come to grips with this risk, while improving credit metrics should enable Bank of America to release excess reserves intermittently throughout 2011. Last year, declining net charge-offs prompted the bank to release about $7 billion held against bad debt.

Bank of America’s credit card business is on the mend as well, thanks to a recovery in consumer spending and declining delinquencies and charge-offs. Although regulatory reform has affected this business line’s profitability, the company has adjusted well to the changes.

The nation’s largest bank repaid all of the loans it received from the Troubled Asset Relief Program, and the firm should be able to meet tougher capital requirements without issuing additional shares. Management has also hinted that improving profitability could open the door for a potential dividend increase. Bank of America is a buy under $6. [Shares closed at $14.75 Friday.—Editor]

[Paul Justice recently recommended an ETF focused on large-cap banks. Jim Jubak likes the earnings trends at his favorite banking giant. But Tom Aspray is not impressed by the technical action in BAC shares.—Editor]

Subscribe to Personal Finance here…

Related Articles on STOCKS

Keyword Image
11 Reasons to Buy Microsoft
12 hours ago

For our latest recommendation, we revisit one of the world's most prominent technology companies, Mi...

Keyword Image
A Trio of Top-Tier Biotechs
12 hours ago

We hold three biotech stocks in our growth portfolio — Biogen (BIIB), Bioverativ (BIVV), and R...

Keyword Image
Saudis, Oil and ETFs
12 hours ago

Under the guise of clamping down on “widespread corruption,” Prince Mohammed bin Salman ...