Fed's cut to add pressure on banks' margins

NEW YORK (Reuters) - The U.S. Federal Reserve's latest rate cut may be the cruelest yet for banks.

The Fed lowered rates by at least three quarters of a percentage point on Tuesday, one of its most dramatic moves yet in a bid to jumpstart a recession-bound economy.

But the Fed easing means that, while the rates at which banks lend will decline, the rates at which they fund themselves cannot fall much further. That, in turn, means any decreases in lending rates -- including the latest -- only squeeze margins.

But stock investors did not seem too alarmed on Tuesday as they sent bank shares up 10 percent, as measured by the KBW Banks index, on optimism the move would help banks by boosting the economy.

But some investors wonder if the markets are taking into account how painful this move could be for banks.

"Banks are going to see a significant drop in their current earnings power and there is no way around that. That's definitely a negative point," said James Ellman, president of hedge fund Seacliff Capital, who said he was "bearish" on many U.S. banks.

UBS analysts estimated on Monday that declining lending margins could cost the U.S. industry upward of $10 billion.

Regional banks BB&T Corp, Comerica Inc, Regions Financial Corp and SunTrust Banks Inc would suffer the largest declines in margins, they said.

"This is a challenge for any bank. We are aggressively managing our liability cost and there are many thing we can do to mitigate the impact of the declining rates," a BB&T's spokeswoman said.

SunTrust declined to comment, while Comerica and Regions Financial did not return calls seeking comment.

'MORE HOPE THAN REALITY'

Those pressures come after financial institutions globally have written down around $1 trillion of assets.

With most U.S. banks trading below their book value, or the accounting value of their net assets, the market seems to have priced in the possibility that banks could write off and mark down more loans.

But investors may not be paying enough attention to the problems banks face even after writeoffs and credit losses have slowed, said Matt McCormick, portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel in Cincinnati.

The slowing economy could tamp down demand for loans. And even if loan demand rises, shrinking margins will hurt results.

"I think the bank share rally today is more hope than reality," McCormick added.

KeyCorp Chief Financial Officer Jeffrey Weeden said in a conference call with investors in October that Fed funds rates below one percent would pressure margins.

"When the funds rate gets down around 1 percent, you end up with deposit rates that are below 1 percent, the ability to go down in the same proportion as any Fed cut becomes very limited," Weeden said.

COMPETITION HEATS UP

Already low deposit rates prevent banks from further reducing their rates, but so does intense competition.

"Based on conversations with several banks, we believe deposit pricing remains unusually competitive," UBS analysts said in a research note on Monday.

UBS expected the U.S. banks' net interest margin to decline between 0.07 and 0.1 percentage points in the fourth quarter and 0.05 to 0.07 percentage points in the first quarter of 2009, representing a nearly $10 billion annual drag to the industry's net interest income.

While it was unclear if any bank would benefit from the lower rates, UBS believed Bank of America Corp and PNC Financial Services Group Inc may be better positioned than most.

(Additional reporting by Dan Wilchins, Editing by Andre Grenon)