Operation Twist Extension
In a recent article we analyzed U.S. Banks expected earnings for the second quarter of 2012. This is a follow up article to explain how the extension of "operation twist" will impact U.S. financials.
In the latest attempt to boost the sluggish U.S. economy, the Federal Reserve has extended 'Operation Twist'. The Fed had to opt for this maturity extension program, as it wanted to refrain from taking other bolder steps. The Fed, through this operation, aims to tilt its balance sheet towards longer maturity by planning to purchase longer-term treasury securities. This would trigger higher demand, and then higher prices of these longer-term securities. The higher price would then lower the yields on these bonds. The Federal Open Market Committee (FOMC) said it would buy $267b worth of securities, whose maturities range between 6-30 years. It also aims to sell securities with durations of three years or less. The sale would put an upwards pressure on their yields, theoretically flattening the yield curve. These efforts are aimed at stimulating the economy by making borrowing costs cheaper for corporations and home owners. Some investors believe that the Fed's efforts are not enough, given the current state of the U.S. economy.
These efforts would have a negative impact on the U.S. financial sector. Typically, banks earn by picking the difference between their borrowing cost, and the rate they charge their customers for mortgage, consumer or commercial loans. The duration of these borrowings, in the shape of customer deposits, is short-term. However, their loans are longer-term in nature. The difference, or net interest margin, that they earn, is adversely affected by maturity extension programs. Banks that are most dependent on interest income, rather than non-interest income, will be the most exposed. Banks like Goldman Sachs (GS) and Morgan Stanley (MS), who have more diversified sources of income, will be in a position to mitigate the impact of this flattening yield curves. These banks have increasingly concentrated on the fees they earn from originating and servicing mortgages, rather than holding on to them in their balance sheets. Only 18% of the total revenues for Goldman Sachs come from interest income.
Banks that are more poised to take some damage include Citigroup (C), Wells Fargo (WFC) and the Bank of America (BAC). Citigroup's Global Consumer Banking Segment's 1Q2012 growth was largely driven by improvement in mortgages, which will be negatively affected going forward. Currently, more than 70% of the revenues of Citigroup come from interest income, followed by the Bank of America, for which interest income is 57% of total revenues. Half of Wells Fargo's revenues come from interest income.
Under U.S. regional banks, Regions Financial Corp (RF), BB&T Corp. (BBT) and PNC Financial Services Group Inc. (PNC), all have the same proportion of revenues accruing from interest income. They all have approximately 65% of revenues coming from interest income, thus they would all have the same impact of the changing yield curve. They have an overall larger exposure to interest income than money-centered banks.
Similarly, spreads earned by REITs that own and invest in agency MBS will be squeezed. Their amortization cost will speed up due to increased prepayments. This will result in depressed earrings. American Capital Agency (AGNC) and Annaly Capital (NLY) are two big names that invest in agency MBS. REITs that own and develop properties will not be hit hard by the flattening of the yield curve. A relative comparison of the 10-year yield with the dividend yield of REITs reveals that RIETs will become even more attractive. The Fed's efforts will decrease the 10-year dividend yields, making REIT dividend yields more attractive.