Analysis: Margin squeeze hurts U.S. banks, may persist

NEW YORK (Reuters) - Low interest rates are cutting into U.S. bank earnings, a problem that may be in only its infancy.

Many large banks this month have reported narrower lending margins, stemming from an inability to lend or invest in securities at rates high enough to offset their cost of borrowing and paying out yields to depositors.

Margin shrinkage can cut into profitability, which could hurt stock prices. And banks cannot count on much new help from the U.S. Federal Reserve, which has kept its benchmark lending rate near zero since December 2008.

"It is hard to see margin pressures going away any time soon," said Arthur Wilmarth, a George Washington University professor specializing in banking law. "Banks at first benefited from Fed rate cuts because they could drop deposit rates immediately while higher-rate loans stayed on their books. But long-term rates have had an opportunity to adjust."

Net interest margin is falling at big consumer lenders such as JPMorgan Chase & Co, Wells Fargo & Co, US Bancorp, PNC Financial Services Group Inc Hudson City Bancorp Inc.

Interest income is also down at trust banks, which hold assets and lend securities, such as Bank of New York Mellon Corp and Northern Trust Corp.

Bank of America Corp and SunTrust Banks Inc may suffer from the same problems when they report quarterly results on Friday. Among the large lenders reporting next week are KeyCorp and Regions Financial Corp.

SIGNIFICANT HINDRANCE

Banks have been looking for new ways to make money since last year's Dodd-Frank financial reform law capped a variety of revenue streams.

Narrower margins could pressure them to seek out additional revenue by boosting lending.

This could help the economy, provided banks do not chase riskier loans, though banks still working off the excesses of the last lending boom may resist taking on too much risk.

Similarly, as higher-yielding investments mature, banks may choose to reinvest in securities that are riskier, or which have longer maturities but are more rate-sensitive, rather than accept lower-yields typically on offer now.

This could backfire if credit quality slides further, or if the economy strengthens and rates rise.

"Because deposit interest rates and other funding costs are so low, banks can't offset a decline in interest income by pulling down their funding costs much more," said Bert Ely, an independent banking consultant. "This is what's really unusual now. And if they reach for yield, banks may mask the pain today by pushing that pain into the future."

Hudson City, a Paramus, New Jersey mortgage specialist, is among the large lenders hardest hit by margin compression.

Chief Executive Ronald Hermance said on Wednesday that as 30-year rates fell below 5 percent, more homeowners refinanced, causing yields to fall on the thrift's mortgage assets.

He said Hudson City's margin may decline in 2011 from the fourth quarter's 1.73 percent -- itself down from 1.97 percent just three months earlier -- and "significantly hinder" the company's ability to post earnings in line with recent levels.

Hudson City shares tumbled by a double-digit percentage over two days after results were released. FBR Capital Markets analyst Bob Ramsey downgraded Hudson City to "underperform," saying margin "should keep heading lower."

DEPOSIT RATES GROW ... SMALLER

While Hudson City's loan quality has long been considered good, that is hardly the case for many other lenders. And excesses that contributed to the nation's four-year-old housing crisis may contribute to margin pressure now.

"Many banks are restructuring mortgages into lower yields to keep them performing," said Tyler Hall, a senior analyst in financial services at SNL Financial LLC. "Some of that pressure comes from regulators who want to keep people in their homes."

Wells Fargo, the nation's fourth-largest bank, saw margin fall to 4.16 percent at year end from 4.25 percent three months earlier. It limited margin compression by selling low-yielding bonds, at a loss. Yet pressures remain.

"If loan demand accelerates that will be great for the top-line, but it may actually reduce the margin if we're not growing deposits at the same fast rate," Chief Financial Officer Howard Atkins said on a Wednesday conference call.

One thing that is not growing is deposit rates.

JPMorgan, for example, this month cut the yield on high-minimum, 13-month certificates of deposit in New York to 0.60 percent from 0.65 percent. The yield was nearly twice that less than a year ago.

Other lenders such as Bank of America are imposing new fees on consumer accounts to help offset the decline in interest income. Such steps might boost revenue, even if they end up weeding out rebelling depositors.

"Because of the impact of Dodd-Frank on fee income, banks face the additional challenge of trying to compensate," Ely said. "This is why banks are upping their checking account charges. I'm highly skeptical of how well that will work."

(Reporting by Jonathan Stempel; Editing by Tim Dobbyn)