For bank investors, interest rates will arguably be the single most significant influence on investment decisions over the next 6 to 12 months. The Federal Reserve's policy of wrestling short- and long-term rates to historical lows can't last forever, and many analysts, investors, and central bankers alike see the end of the loose money in the not-so-distant future.
How do interest rates impact my investments?
For traditional banks, profitability is all about interest rates. These banks make loans and charge interest. They fund these loans primarily with deposits that pay a lower interest rate. The difference, plus a little extra revenue from fee income and other miscellaneous services, must be sufficient to pay for operating expenses and provide a profit.
Wells Fargo (NYSE:WFC), for example, generated 50% of its total revenue in Q2 2013 from its net interest income (that is, the interest it collected from loans minus the interest it paid out to depositors). Of the largest U.S. banks, Wells is by and large considered the most traditional, and as such, it has a higher percentage of revenue tied to net interest income.
Goldman Sachs (NYSE:GS), for comparison, is traditionally an investment bank, and net interest income is only a marginal part of its overall profitability. For the second quarter, Goldman reported just 9.6% of its total revenue from net interest income. The rest was spread out among investment banking, securities, market making, and other corporate services.
And of course there are banks that sit in the middle, like JPMorgan Chase (NYSE:JPM). JPMorgan is the largest player in the derivatives market and has a major presence in the investment banking and securities world. However, it still relied on net interest income for 42% of total revenue.
Going back to Econ 101
Of the examples here, Wells Fargo is most exposed to shifting dynamics in interest rates from the standpoint of interest income. However, there are other dynamics at play.
Banks sell financial products, many of which are tied to interest rates (think loans and deposits). For consumers, the interest rate is effectively the price of purchasing that product. Over the past few years, the mortgage refinancing business has been booming as consumers have sought to lower their interest rates on existing mortgages. Simultaneously, first-time homebuyers were more likely to buy a home because the price of a mortgage was so low.
Thinking back to Econ 101, as prices rise, demand will fall. So if interest rates (price) rise, demand for mortgages and other loans will fall. For Wells Fargo, which reported that 26% of its non-interest income came from mortgage-related activity, there is a huge risk that demand for its its products (loans) will significantly fall with a rise in interest rates. JPMorgan is slightly better positioned, here, with respect to the mortgage business, with 12.6% of non-interest income derived from mortgages.
This concept applies to other bank products beyond the mortgage. Goldman Sachs' investment banking business could suffer if firms can no longer find funding cheap enough to justify a buyout or takeover.
On the other hand, higher rates can be a good thing for banks, too. From the mortgage example above, if interest rates rise, there will be a decline in demand, but not a 100% decline. For those borrowers who still move forward with the loan, the bank will receive more interest income because of the higher rate.
What's going to happen in the next six months?
As an investor, it's critical you understand how changing interest rates will impact your bank of choice. Because like it or not, interest rates are already changing, and it's going to get a lot more volatile before the dust settles.
In my view, the road from historically low rates to a more normalized environment will be a particularly rocky one. Market makers and complex shops like Goldman Sachs and JPMorgan will likely find abundant opportunities to profit from this volatility. Over the long term, simpler banking models like those employed at Wells Fargo and smaller regional institutions will continue to succeed and prosper; however, in the transitional period, I expect them to underperform.