In many respects, the lending business has really always been a leveraged bet on interest rates. With investment-grade credit ratings and a variety of funding sources, the larger money-center banks can borrow short-term and lend long-term, turbo-charging the spread arbitrage whenever possible.

Sure, credit risk management skills come in handy during the bottom of each credit cycle. But in the right economic environment, this "excess spread" game can become a license to print money. In the good old days of a steeper yield curve environment, leading banks could almost put their spread business on cruise control, with added margin cushion compensating for deadbeat credits. Market conditions allowed the bigger players more time to focus on acquisitions and the development of other, more diversified income streams.

Of course, ATM fees and investment banking income have helped many banks to stabilize profits in those "off years," not to mention the unprecedented bull market in real estate lending. But for how long can banks really be expected to rely on growing these non-core businesses to sustain long-term competitive growth? In order for banks to survive, they must continue to generate spread income by lending money. In the money lending business, maximizing your net interest margin (NIM) is the name of the game.

But in recent years, a flatter or inverted yield curve has made this game much more difficult. With three-month yields currently besting 30-year rates by 30 basis points, asset/liability management has become a virtual high-wire act. In 2006, we've seen the 10-year Treasury yield range from a high of 5.24% in July, to around a 10-month low of 4.43% on Dec. 1. The yield curve has shown no mercy on bank profit margins.

Consider this year's earnings releases for Citigroup (NYSE:C), Wachovia (NYSE:WB), and Bank of America (NYSE:BAC). Each of these lenders has consistently reported a steady compression in NIM over the last three quarters.












Bank of America




Citigroup has seen its share price rise a measly 3.31% over the last 12 months, and Wachovia's shares are up a mere 3.24%. Although BofA's share price performance has been more in line with the broader market this year, its NIM figures are still much lower than its historical standards:

Bank of America Historical NIM

2001 3.61%









Although the trend is disturbing, history tells us that the yield curve is cyclical, so rates can't remain this way forever. In a Q4 release, the Philadelphia Fed sees a stabilizing NIM, which means that the bleeding has already begun to slow. But when will the yield curve cooperate and make lending fun again? Let's not forget that in 1992, the difference between three-month T-bills and the 30-year bond was 500 basis points. Just imagine the possibilities.

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Fool contributor Michael Mancini owns shares of Bank of America. The Fool has a disclosure policy.