Yield curve helps banks but credit troubles loom

NEW YORK (Reuters) - Banks have seen lending margins jump thanks to a widening gap between short- and long-term interest rates, but that one bright spot for banks may be overshadowed by credit losses as the economy slows.

The gap may widen further in coming months, reversing a recent narrowing trend. But even so, banks' bottom lines could be increasingly pressured by bad loans, meaning the outlook for the battered sector remains grim, analysts said.

"It's a Darwinian process out there, and the weak are getting weaker," said Michael Holland, who oversees more than $4 billion of assets for Holland & Co.

The news isn't all bad. Returns on many bank assets, such as loans and corporate bonds, are rising as risk premiums jump.

And the gap between the short-term rates at which banks borrow and the long-term rates at which they lend is likely to stay relatively wide as long as the U.S. Federal Reserve is concerned about economic growth, and inflation concerns linger.

Bank stocks, as measured by the KBW Banks index .BKX, are now up about 40 percent from their lows earlier this month.

"They probably will keep short-term rates low through the election and give banks the chance to refinance themselves," said Jim Cusser, senior vice president and portfolio manager with Waddell & Reed Investment Management in Overland Park, Kansas.

For much of 2005 through the early part of 2007 banks faced serious pressure on their margins from the negligible or even negative difference between the short-term rates at which they borrowed and the long-term rates at which they lent.

The Fed had been raising short-term rates, while overseas investors, including foreign central banks continued to pour funds into long-term bonds, keeping those yields relatively low.

Since then, the gap between those two rates has widened, as the Fed has cut rates and inflation concerns have mounted. The wider gap has boosted margins and offered banks much needed relief from the harshest conditions in some markets since the Great Depression. Financial companies globally have recorded more than $400 million of writedowns over the last year.

The Fed's low short-term interest rate is keeping short maturity yields down, while inflation concerns, which erode bond values over time, tend to put more upward pressure on the yields of longer maturity notes and bonds.

SECOND QUARTER BENEFIT

The benefit of the widening gap between short- and long-term rates was evident in the second quarter.

For example, Citigroup Inc's (C.N) net interest margin, a measure of its lending margins, jumped to 3.18 percent in the quarter, from 2.41 percent in the same quarter a year earlier.

A good proxy for banks' lending margins is the gap between the two-year Treasury note yield, which tends to track closely the rate at which banks can borrow, and the 10-year Treasury note yield, which is nearer the rate at which banks invest.

The gap between two- and 10-year rates was just a little bit more than zero at the end of June 2007, while for much of the second quarter of 2008, the gap was above 1.45 percentage points.

The gap has narrowed moderately in recent weeks, but some strategists see it widening in the next few months, if it becomes clearer the Fed won't lift short-term rates, and longer-term rates stay relatively high.

"The market has attempted to price in Fed rate hikes and we just do not see the Fed being able to hike," said T.J. Marta, fixed income strategist with RBC Capital Markets in New York.

BAD LOANS

But weak loans will still pressure banks. For one thing, banks will likely have to boost their loan loss provisions in the coming quarter as areas like commercial real estate weaken further.

The two biggest commercial real estate brokers and leasers in the world reported dismal profits on Tuesday, and their shares dropped on Wednesday, signaling more difficulty is ahead for commercial real estate.

Bad loans can also pressure net interest margins, because banks don't get interest payments on those loans, but must still pay off the liabilities funding them. Banks must also remove any benefits they've received in prior quarters from non-performing assets.

For stronger banks, that's less of a concern, but for weaker banks, it can be a big problem.

"The environment for banks will continue to be very challenging," said Steve Persky, chief executive at Dalton Investments in Los Angeles.

(Editing by Leslie Gevirtz)