By Investment U
If you were around in the ‘70s, you may recall the episode of the sitcom Happy Days in which Fonzie (in his trademark leather jacket) jumped over a shark pen on water skis.
This had been one of television’s most popular shows, but the shark-jumping episode marked the beginning of its decline. The term “jumping the shark” would go on to become synonymous with reaching a point where there’s nowhere to go but down.
Which brings me to banks and insurance companies.
Over the past few months, analysts have been shouting from the rooftops that banks and insurance companies are the best way to play rising interest rates. But I think the current outlook for these companies has reached a point of inevitable decline. In short, they may have jumped the shark.
First, let’s look at banks.
Many analysts describe banks as “black boxes” – hard for ordinary investors to understand. But banks’ business models are actually pretty basic. Banks make money on interest rate spreads and fees.
While interest rates were low, more people refinanced their mortgages. This generated hefty fees for the banks taking on the risk of lending money.
Now that interest rates are on their way up, they will make money on the interest rate spreads. The only problem here is that fee revenue is drying up and rates aren’t likely to see the sharp increase needed to make up the difference.
After touching 1.6%, the 10-year yield soared as high 2.7%, pushing up mortgage rates along with it. It’s currently sitting at 2.65%.
This dramatic rise in rates has effectively shut off the spigot in refinancing – possibly all at once. Deciding whether to refinance boils down to how much money you will save. The recent shock that we’ve seen as rates rose quickly has offset more than a year of rate declines.
If you don’t believe me, check it out for yourself. Pick up the phone and call your mortgage banker. I’ll bet the phone doesn’t ring twice before he answers. That’s because they aren’t very busy.
This could be a bigger problem than people believe.
To put this in perspective, Wells Fargo (NYSE: WFC) generated more than 10% of its revenue from mortgage fees. Even though the housing market appears strong, 56% of new loans were refinancings. This is a very large number and while total loans were up year-over-year for Wells Fargo, they were down at JP Morgan Chase & Co. (NYSE: JPM).
The party may be coming to a close.
Many analysts argue that this refinancing revenue will be replaced by revenue from wider interest rate spreads. As rates rise, banks take customer deposits (with miniscule rates) and buy long-term investments at higher yields, further in the future.
This may replace some of the lost revenue. But a major slowdown in a segment as large as 10% of overall revenue is unlikely to be completely offset by rising spreads.
Insurance companies look to be in somewhat better shape. But their flaw is that they will see asset values drop.
Here’s why.
Insurance companies’ premiums are essentially pre-payments of a future claim. Since claims are often made months or years after premiums are received, insurance companies capture the float, which is invested in short- and long-term securities. As yields rise, earnings will increase as premium payments are invested at higher rates.
Unfortunately, as yields rise, the price of the bonds these companies are invested in will decrease because the cost of borrowing increases (remember: as rates rise, bond prices fall and vice-versa). This makes the book value of the portfolio decline. For example, a rise in rates from 4% to 6% could cause the price of the bonds in the portfolio to drop as much as 20% – if the duration of the portfolio is only 10 years.
The decline in portfolio value may not impact earnings since these bonds are often held to maturity, but there could be a large shock to overall book value.
On top of the deterioration of portfolio value, insurance stocks have dramatically outperformed with the Powershares KBW Insurance ETF (NYSE: KBWI) up 31% this year. It’s clear that expectations are now high for this sector.
Despite the lure of easy money, sometimes you have to force yourself to stay disciplined. If you have profits in banks and insurance companies, consider taking a little and directing it to simpler, pure plays that don’t have offsetting profit streams.
Good Investing,
Tom Anderson
Article By Investment U
Original Article: Rising Interest Rates Mean Trouble for Banks, Insurers