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Why I Like Banks

Richard Croft
August 19, 2013
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Before getting started with this weeks’ blog I need to correct something reported last week. In discussions about US interest rates I talked about the US 10 year Treasury yield and mentioned resistance at 2.5%. That was a misprint, it should have read 2.7%. My apologies.

The reason I wanted to raise this – besides wanting to correct a mistake – was to explain the dynamics underpinning this very important demarcation line. The bond market is factoring in higher rates despite any noise around Fed tapering.

To explain tapering one more time let’s understand that we are talking about the bond buying program referred to as the third iteration of quantitative easing (i.e. QE III). The US Federal Reserve (Fed) has been engaging in QE III since late last year.

In short the Fed has been purchasing approximately US $85 billion per month in government bonds and mortgages. Because the Fed is a major buyer of these securities bond and mortgage backed securities prices have been propped up artificially meaning these prices are higher than one would expect to see in a normal interest rate environment. The rationale behind the strategy is to keep mid to longer term interest rates artificially low. Note the teeter totter effect of bond prices and interest rates to wit; higher bond prices means lower yields.

This problem with this strategy is that involves the Fed’s balance sheet which means that the central bank is effectively printing money. Printing money at a faster pace than the economy is creating new goods to buy eventually causes inflation. Since managing inflation is a key mandate of all central banks at some point bond buying programs must end.

Tapering is a term coined by Fed governors that was intended to inform the market that the central bank is setting in place a strategy to end QE III. Consensus among Wall Street analysts is that tapering will begin in September and within 12 months the Fed will have completely exited the program.

By removing one of the largest buyers of government bonds and mortgage backed securities prices for these instruments will fall in order to attract private sector buyers. Returning again to our bond price interest rate teeter totter lower bond prices means higher yields which presumably will attract buyers who have been seeking yield alternatives among preferred shares and high dividend paying common shares.

Of course the Fed does not have to actually begin tapering before the market reacts. That’s because financial markets are forward looking and the market will adjust rates on the premise that tapering is coming to an end regardless of any specific time line.

To that point we return again to the yield on US 10 year treasury bonds that closed Friday at 2.83% up 30 basis points (0.30%) in the last month and 101 basis points (1.01%) over the last year. The fallout from higher government bond rates explains why preferred share prices have waned and high dividend paying common stocks such as shares of Utility companies have underperformed over the same time period.

What we know then is that interest rates are clearly on the rise. And while tapering talk may be interesting fodder for financial news networks the actual time line for Fed action is irrelevant. Investors need to position their portfolios for higher interest rates using securities of companies that will benefit in this environment.

As you know I have been touting the potential of financial service companies like banks because they will benefit from higher net interest margins and insurance companies that hold long term fixed income portfolios as the offset to fixed liabilities.

In our continuing effort to keep readers informed I think it is important to detail the logic underpinning this affection for banks and insurance companies. For that I want to look specifically at banks where I will try to explain the nuances of the net interest margin, why it will expand and what it will do for bank profitability.

Net interest margin is the difference between what a bank pays for capital and what it can get for lending out that capital. Typically when investors think about a banks’ net interest margin they compare current average loan rates to say, GIC rates.

For example, if a five year GIC is paying 2.5% and a five year fixed term mortgage is 3.05% the net interest margin is 0.55%. But that simple calculation tells only part of the story. When you take into account a banks reserve requirement the numbers change dramatically.

For an explanation consider some nomenclature which is not necessarily how a bank might report it in their annual financials but for our purposes will help us explain the metrics in a language everyone can understand.

We begin with the term “Deposits” which represent the money banks hold in savings and checking accounts as well as money deposited in GICs. In effect the bank is borrowing these funds at a rate that is determined by supply and demand.

Suppose you buy a $1,000 GIC with say a one year term. Further we will assume the current reserve requirement is 5% which means that banks must hold at least 5% of their capital unencumbered.

You might think the bank could lend out $950 of that GIC at a higher rate but that would be wrong. In fact the bank can leverage that Deposit by 20 times that amount or $20,000 ($1000 divided by the 5% reserve requirement = $20,000) which we will call the banks’ “Lending Capacity”. Table 1 sets out the numbers.

Table 1
Deposits $ 1,000
Reserve Requirement 5.000%
Lending Capacity $ 20,000

Turning our attention to the net interest margin let’s account for the costs the bank incurs to create that lending capacity. We will assume for purposes of this discussion that the bank will pay 2% per annum for the GIC but pays nothing for the funds that are available for lending purposes. As such the bank pays 2% on the initial deposit plus zero on the $19,000 leverage capital resulting in a net cost of capital of 0.10%. Assuming those funds can be loaned out essentially risk free to the US government at 2.83% (i.e. the rate currently payable on ten year US treasury bonds) the resulting net interest margin is 2.730%. Table 2 details the numbers.

Table 2:
Net % Cost of Money Capital Int. Rate $ Cost
Deposit Rate $ 1,000.00 2.000% $ 20.00
Reserve Capital $ 19,000.00 0.000% $ –
Net Interest Margin 0.100% $ 20.00

Net Interest Margin Income Int. Rate
Lending Capacity $ 20,000.00
Cost of Money $ 20.00 0.100%
Loan Rate $ 566.00 2.830%
Net Interest Margin $ 546.00 2.730%

Now compare that to what a bank would have earned just 30 days ago when US ten year treasury yields were 2.53% (see table 3).

Table 3:
Net % Cost of Money Capital Int. Rate $ Cost
Deposit Rate $ 1,000.00 1.750% $ 17.50
Reserve Capital $ 19,000.00 0.000% $ –
Net Interest Margin 0.088% $ 17.50

Net Interest Margin Income Int. Rate
Lending Capacity $ 20,000.00
Cost of Money $ 17.50 0.088%
Loan Rate $ 506.00 2.530%
Net Interest Margin $ 488.50 2.443%

In just the last thirty days the net interest margin has gone from 2.443% to 2.730% an increase of 11.77% (2.730% divided by 2.443% minus 1 = 11.771%). Think about that; an 11.77% increase in margins over the last 30 days and that is in a slow growth environment.

These numbers also explain why banks are reticent to make higher risk loans when their profitability can expand so dramatically with risk free debt. And when banks do make mortgage loans at higher rates (which is exactly what Canadian banks have been doing for some time) with essentially the same cost of capital the net interest margin numbers can have an exponential effect on the bottom line. Moreover because of the timing of the Fed’s tapering comment (note: Bernanke first talked of tapering during the last week of June just before the books closed on second quarter earnings) those margins were not factored into second quarter numbers. But even without that the financial services sector generated some of the strongest earnings growth in the second quarter.

Of course there are risks. If the North American economy remains on a slow growth trajectory demand for higher rate loans will wane. But even taking that into consideration there remains plenty of supply of risk free paper from governments.

There are additional positive implications from a slow growth trajectory in terms of its impact on the reserves banks’ have set aside for bad loans. As real estate stabilizes there will come a point when banks can reduce those reserves which goes directly to their bottom line. Providing yet another bump to profitability through the remainder of this year and into 2015 which most analysts think is the minimum time line for exceptionally low interest rates.

There lies the logic for why I like banks which I think will provide some real oomph to your portfolio over the next six months. Notable investments include long term calls on any the big five Canadian banks preferably held inside tax free savings accounts.

To that latter point the Canadian story is particularly relevant in terms of buying the individual shares. I expect Canadian banks, who do not have to receive permission to return capital to shareholders, will raise their dividends which is your best defense to higher interest rates.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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