Spread Thin

Banks have plenty to worry about as they navigate the current choppy economic waters. The ongoing lending crisis, caused by some $1 trillion in losses due largely to defaults on risky mortgage loans, is an ongoing story, to be sure. But banks are also dealing with decreased profit margins due to a historically narrow net interest spread. While the region’s financial institutions remain relatively healthy, the profitability issue is yet another obstacle to overcome — in a year that has posed far too many already.

How does a bank not make money?

It’s a question plenty of Americans have certainly asked. One answer can be found on the margins.

At issue is something called ‘net interest spread,’ which is essentially the difference between the interest yield that banks earn on loans and other assets, and the interest rates they pay on funds they borrow from the government and other banks.

That spread gives a good idea of how profitable the industry is at any given time, and right now, the margin is razor-thin — another wrench at a time when many banks are struggling simply to remain afloat.

“The federal funds rate today is as low as it’s ever been,” said William Hogan Jr., president of Easthampton Savings Bank. “But deposit rates have fallen as lending rates have fallen, and the difference between the two is tight today.”

“The spread is the difference between the cost of funds and earning assets,” explained Richard Collins, president of United Bank. “The rates go down and up all the time. Our job as bankers is to do our best to balance the impact and make a profit. But the yields on earning assets stayed flat this year, and that’s now starting to affect our portfolio. That puts pressure on the margins for a lot of banks.”

It’s pressure many executives say they don’t need right now, in the midst of a banking crisis that saw some two dozen institutions go under last year, and credit markets seize up after banks took more than $1 trillion in writedowns and credit-market losses since 2007, driven largely by record subprime loan defaults.

“I’m always an optimist, but a careful one,” said David Glidden, regional president of TD Banknorth, adding that he believes the economy will worsen, at least in the short term. “I think we’re going through historic times, and really uncharted waters, so to speak.

“I’m optimistic that the economy is resilient, and the credit markets are resilient and will come back,” he continued. “But I do not think we’ve hit bottom, and we’re going to see things get worse before they get better.”

Profits and Loss

Hogan said a whole host of factors can put unusual pressures on bank profitability, but they tend to be more apparent during a recession.

“When times are good, you can overlook some of these factors,” he said. “But there’s a cumulative effect from all the issues that the financial-service business is dealing with today, from the economy to the new and increased regulations.”

One such factor, said Hogan, is suddenly increased premiums from the Federal Deposit Insurance Corp. (FDIC), which protects consumers’ deposit and savings accounts, due to the rash of bank failures over the past several months.

“The problems of Wall Street are reaching Main Street, so to speak, and we’re all painted with the same brush. In a lot of ways, we’re paying for the sins of our financial brothers; FDIC insurance premiums are up dramatically because of the need to clean up bank failures. We’ve got to kick in to help fund that.”

It doesn’t help that banks are facing a significant loss of confidence, said Glidden, which makes him even more relieved at the relative health of his own institution.

“We are still actively lending,” he said. “Fortunately, we avoided a lot of the credit problems that have plagued the larger money-center banks.

“Like anybody, we’re being prudent because of the economy and what’s going on in the market,” he added. “Nationally, lending overall is clearly still restricted. But hopefully, some of the things the federal government is doing will unclog the financial system, which is really clogged up.”

One key obstacle, he explained, is bank-to-bank lending, a generally robust activity during better economic times. “There’s just none of that going on right now,” Glidden said, “because banks don’t trust other banks’ balance sheets. There’s no confidence in the system.”

That’s understandable, said Collins. “A lot of banks are taking writedowns on securities they hold. Other banks hold these exotic mortgage-backed securities — toxic securities — and if you own those, your major problem is profitability. A few bad securities can wipe out a lot of interest margin.

“That continues to be true all over,” he added, “but we haven’t seen that story here. Our bank has not been hurt by subprime loans and toxic securities.”

That’s a trend that’s true throughout Western Mass., in fact, as many regional banks tout their freedom from the sort of bad loans that have sent so many banks reeling.

“We’re very busy, and the message we’ve been telling people is that we have money to lend — and, by and large, we’re doing that, and at the same terms and conditions we were years ago,” Hogan said. “We really haven’t tightened our restrictions or made it more difficult, generally, for people to get loans, and we have an active pipeline of loans in process right now, from home mortgages to consumer loans to commercial real estate and lines of credit for businesses.”

The main reason, he explained, is that the bank is not only well-capitalized — its capital ratio is 11.3%, more than twice the level suggested by the FDIC — but, like other Western Mass.-based banks, totally unencumbered by toxic securities.

“We’ve never made a subprime loan; we never did these wild and crazy loans with no documentation or income certification, with little or no down payments,” he said. “We’ve never ventured into those, and we haven’t swayed from business as usual.”

Back in the Saddle

Confidence in the financial-services industry has affected consumers in more ways than one. Consider, for example, the yield spread when it comes to mortgages.

At press time, the spread between 30-year mortgages and 10-year Treasury notes was the largest in two decades, even though the average 30-year fixed-rate home loan was below 5%, the lowest in at least 40 years.

Spreads are even wider for adjustable-rate mortgages; the average 1-year ARM is almost 5.8% above three-month Treasury bill yields, almost three times the typical spread.

Those trends have given rise to consumer calls for further mortgage rate reductions, but economists say banks are skittish after taking that aforementioned $1 trillion in credit losses.

“Underwriting criteria have been tightened considerably, and that is a real issue,” said Douglas Duncan, chief economist at Fannie Mae, in Finance and Commerce, an online business news source. “Mortgages could well be close to 4% if they reflected traditional spreads. It’s not greed or things like that. It’s the real risks the banks see.”

Even a healthy bank like TD Banknorth — it’s one of only four AAA-rated banks worldwide, when only recently there were 27 such institutions in the U.S. alone — isn’t immune to such anxieties, Glidden said, but neither is it time to panic.

“We have plenty of liquidity and strong capital. We’re a profitable company, but in this marketplace, we’re trying to focus on our customers, our core franchise, and prudent growth,” he said.

“In this environment,” he continued, “you can still grow, but I think you have to be very measured in finding your opportunities and executing a plan, because it’s the furthest thing from business as usual right now — and some boats are going to be lost in this tide.”

Many already have. For those that remain afloat, maximizing profits remains a delicate balancing act, as they wait for the economy — and industry confidence — to return.

Joseph Bednar can be reached at[email protected]