Everyone is applauding JP Morgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) about their Q1 numbers. Red ink has turned black in many categories. Much improvement has been experienced in credit loss reserves. It’s always nice when you stop losing money because your customers are now able to meet their obligations. Not exactly genius more in the fundamental must have category. So if you believe the economy is improving as both sets of executives maintain you will see gradually improving fundamentals. Wells Fargo even went so far as to say that loans and mortgages taken on now in the early stages of the recovery have less risk than loans and mortgages taken on in the latter stages of the economic cycle [some would say bubble]. Hard to argue so far.
But think in terms of game changers. Nothing ever goes in a straight line. Financial institutions live and die by their ability to maintain adequate net spread. That is the difference between what funds cost and what they can charge their clients who can meet their obligations. Interest rates are at historically low levels. Yield oriented depositors and investors are only too aware of the pain and suffering low-interest rates have exacted.
The market dynamic in a rising interest environment will be for borrowers to attempt to lock in long while providers of funds in whatever form will attempt to stay short and lock in better rates higher up the cycle. This happens every time. Also while the credit risk seems to be improving as loans and mortgages increase in cost a lot of underwriting starts to fall apart. most consumers will struggle with an extra three percent cost on their mortgage.
We may already be seeing the beginnings of margin compression. Concern has been raised about JP Morgans increased cost of long-term debt which would be provided by bond investors who should be the smartest guys in the room when it comes to interest rates.
Do not be lulled into a false sense of security with the two supposed better names in the banking sector. They will all experience the same challenges of margin compression. It happens with every increase in the interest rate cycle. So far management is whistling through the grave yard and not speaking about it.
Iceberg straight ahead!
George Gutowski writes from a caveat emptor perspective.