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Now Is an Extraordinary Time to Play this 'Spread'By
Monday, May 11, 2009
Back in the 1970s, the banking business was described as a "3-6-3" business... You borrowed at 3%, lent at 6%, and were on the golf course by 3 p.m.
Back then, there was so much business and so little competition, small-town bankers could earn a 3% interest spread – the difference in interest rates between what a bank earns on its loans and what it pays on its deposits – and still fit in a round of golf before dinner. Today banking is much more complicated than it was in the 1970s... and it's also much more competitive. But the basic business hasn't changed: If a bank is earning a positive interest spread, it's making money. It's as simple as that. And right now, the banking industry in general is earning interest spreads so wide, they're close to breaking all-time highs. I estimated the interest spread of the banking industry by subtracting the yield on the two-year Treasury note from the yield on the 10-year Treasury note. Even though banks don't actually use these Treasury rates in their businesses, the difference between the two-year and the 10-year rate shows you how steep the yield curve is... which gives you a good estimate of the interest spreads bankers are making. Right now, the spread between the two-year note and the 10-year note is 2.32%. The spread has only been higher than this three other times in American history. In 1992, it reached 2.65% and in 2003, it set an all-time high at 2.74%. Finally, last November, it peaked at 2.61%. (Hat tip to Across the Curve for this data.) In other words, right now, with the yield curve at 2.32%, the banking industry is earning record interest income. Take Bank of America as an example. It takes money in from depositors. Depositors can get their money back whenever they want. If the bank does tie their money up, it's usually for less than a year. These depositors receive the lowest interest rates in the market. I just checked at my local branch, and right now Bank of America pays 1.9% on a one-year CD. Bank of America lends its cash to homeowners, businesses, consumers, and other banks as long-term loans. Long-term loans often come with higher interest rates than short-term loans. Take a mortgage as an example. Bank of America earns over 5% for lending to homeowners for 30 years. In the first quarter of 2009, Bank of America made a 0.68% interest spread from its portfolio. It may not sound like much, but a 0.68% interest spread with leverage translates into fantastic cash flow for shareholders. Check out the last three years of Bank America's net interest income from its loan portfolio.
Bank of America has problems with the bad loans it made during the boom. No one knows what these loans are worth... or if Bank of America has enough capital to cover the losses if these loans turn bad. So I wouldn't touch bank of America's stock right now... However, because the yield curve is close to record steepness, I am bullish on the banking business in general. I especially like banks that don't have problems with bad loans. Virtual banks like Annaly are one example. Virtual banks borrow at short-term rates and hold portfolios of federally guaranteed mortgage bonds. They should be able to earn more interest income now than ever before... and pay huge dividends. Good investing, Tom P.S. You can learn the full story about stocks like Annaly here and here.
Further Reading:
The Best, Safe Investment of 2009 Pays 19% Interest Market Notes
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