Citigroup, Bank of America Squeezed by Bond Market

Citigroup, Bank of America Squeezed by Bond Market
By Mark Pittman
Bloomberg, 2006-08-29

Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. are among the biggest losers in the bond market, where the largest U.S. banks' relative borrowing costs are the highest in three years.

A slowing economy has prompted investors to demand an additional 11 basis points of interest, or $1.1 million for each $1 billion face amount, on bank bonds since February, according to data compiled by Merrill Lynch & Co. The widening yield premium amounts to a loss of $7.3 billion on bondholders' principal the past six months and a profit squeeze for banks, which make money on the difference between their borrowing and lending charges.

Bank bonds, which account for almost one fifth of the $5.2 trillion U.S. corporate bond market, are heading for their worst year since 1999 after the Federal Reserve increased interest rates 17 times, the government reported a 4.3 percent slump in new-home sales in July and oil prices rose 14 percent since January. Slower growth may cause bond defaults to quadruple by 2008, adding to bank losses, Standard & Poor's says.

``Whenever you see some weakness in the economy, that has to get into investors' minds,'' said Alvaro de Molina, chief financial officer of Bank of America, in an Aug. 24 interview. Some fund managers may be questioning whether the Fed has pushed the economy into a recession, de Molina said.

Investors are demanding 81 basis points more than the yield on similar-maturity Treasuries. The spread was as high as 83 basis points on Aug. 11, which was the most since 2003. The spread has widened twice as much as the 5 basis point increase in yield premiums, or spreads, for investment-grade bonds, according to Merrill. A basis point is 0.01 percentage point.

Falling Prices

Bank bond prices have fallen on average 2 percent this year, according to a Merrill index that tracks the performance of 579 securities worth $365 billion. By contrast, the Merrill index of AA rated debt declined 1.8 percent this year.

The total return on the bank index, including both capital appreciation and reinvested interest, is 1.64 percent this year, the worst since it declined 1.73 percent in 1999.

Citigroup's $1 billion of 6 percent bonds due in 2033 have fallen 7 cents per dollar of face amount this year to 99 cents as the yield climbed to 6.06 percent from 5.6 percent, according to Trace, the bond-price reporting service of the NASD. The spread has widened 10 basis points to 1.11 percentage points since Jan. 1.

Citigroup spokeswoman Shannon Bell in New York declined to comment.

JPMorgan's $1 billion of 5.875 percent notes due in 2035 have fallen 6 cents per $1 face amount to 94 cents since the first of the year, according to Trace. The bond's yield has gone up 45 basis points to 6.31 percent.

JPMorgan spokeswoman Brooke Harlow declined to comment.

Threat of Default

A slowing economy also may cause a growing number of borrowers to default, requiring banks to set aside more money for losses and leaving less for debt payments. Defaults will rise to 4 percent from their current record low of 1.03 percent by the first quarter of 2008, according to S&P.

``We're probably at the top of the mountain for loan quality, and it's going to start falling pretty soon,'' said James Hannan, who oversees $3 billion in fixed income at MTB Investment Advisors in Baltimore.

Hannan, whose holdings include bonds of Charlotte, North Carolina-based Wachovia Corp. and Mellon Financial Corp. of Pittsburgh, said he is seeking debt of banks that make money from trading, underwriting and advisory services. He's avoiding companies that focus on housing loans, such as Calabasas, California-based Countrywide Financial Corp., the biggest U.S. mortgage provider.

Investors now demand 23 more basis points in yield over government debt, or 1.36 percentage points, to hold Countrywide's $1 billion of 6.25 percent notes than when they were sold in May. The securities mature in 2016.

Yield Premiums

The average yield premium for banks has widened 11 basis points from the low this year of 70 basis points in February, saddling bank bond investors with the biggest losses, Merrill data show. Bonds sold by companies in the telecommunications industry lost $5.3 billion because of declining prices.

Banks have $30.7 billion in debt coming due by year-end, more than any other industry, according to data compiled by Bloomberg. Bank of America has the most, or $5.7 billion, just ahead of the $3.5 billion for Minneapolis-based U.S. Bancorp.

Higher borrowing rates have contributed to shrinking lending margins, a measure of profitability. S&P said earlier this month that those margins are at their lowest since 1991.

Interest Margins

Citigroup's net interest margin, the difference between the average rate the bank pays to borrow and what it charges in interest, fell to 2.8 percent in the second quarter, the lowest since at least December 2000.

The net interest margin at New York-based JPMorgan has shrunk to 1.96 percent, the smallest since September 2001. The rate at Charlotte, North Carolina-based Bank of America is 3.02 percent, the lowest since at least March 1999.

Lending margins are ``a key factor in their earnings, and they're continuing to see some pressure,'' Baylor Lancaster, a Coconut Grove, Florida-based analyst from debt research firm CreditSights Inc., said in an interview. ``We view a future deterioration in credit quality as pretty much inevitable,'' Lancaster said in an Aug. 8 report.

Commercial banks make about two thirds of their income from the difference between their borrowing and lending costs, according to James Moss, an analyst at Fitch Ratings in Chicago. He said a 1 percentage point increase in benchmark interest rates could reduce profit on average by 4.6 percent.

Sell Bank Bonds

Investors ought to sell bank bonds or buy derivatives that would benefit from a decline in the price of debt issued by Wachovia and Citigroup, said Barclay's Capital analysts Melody Vogelmann and Julie Schultz in an Aug. 17 report.

Wachovia, the fourth-largest U.S. bank, has few operations outside the U.S., so it would be hurt by a slower U.S. economy more than other competitors, Vogelmann and Schultz said.

``No question, it's a headwind with regard to revenue growth,'' said Bank of America's de Molina. Higher borrowing costs won't hurt credit quality because the bank can make up the lost revenue in other ways, he said.

By de Molina's estimate, the worst-case scenario for interest rates next year would cost Bank of America about $600 million. The bank will earn $20 billion this year, according to the average forecast of 16 analysts surveyed by Thomson Financial.

``That's a pretty small number in comparison to a $20 billion revenue stream,'' de Molina said

Target Rate

Fed policy makers this month decided not to raise borrowing costs after pushing their target rate for overnight loans between banks to 5.25 percent from 1 percent in June 2004. New-home sales in July fell more than forecast and the number of unsold houses climbed to a record, according to a Commerce Department report released last week. Purchases of new homes dropped to an annual pace of 1.072 million.

The central bank should have stopped earlier, according to Robert Shiller, the Stanley B. Resor Professor of Economics at Yale University in New Haven, Connecticut. Shiller, the author of the book ``Irrational Exuberance'' that in 2000 predicted a slump in the stock market, said this month that a slowdown in the housing market will likely cause a recession.

``Banking spreads are going to widen much more meaningfully than they have now,'' said Nouriel Roubini, a professor of economics at New York University. ``The banking system as a whole is hugely vulnerable to the risk of recession.'' Roubini says there is a 70 percent chance of a recession.

Consumer Confidence

Confidence among consumers this month fell to its lowest since October because of concerns about terrorism and high gasoline prices, the University of Michigan said Aug. 18. The school's preliminary index of sentiment dropped to 78.7 from 84.7 in July.

Almost 30 percent of banks said they anticipate residential mortgages will deteriorate over the next year as the housing market cools, an Aug. 14 report by the Fed said.

``Banks will tighten their lending standards by increasing loan spreads and by simply refusing to lend to some at any spread,'' said Paul Kasriel, director of economic research at Northern Trust Securities, in an e-mail on Aug. 18. ``This, in turn, will create even more drag on economic growth.''

The three biggest U.S. banks all reported record profits last year led by Citigroup's $24.6 billion. Bank of America's net income totaled $16.5 billion and JPMorgan had $8.5 billion.

Corporate Lending

Bank of America has scaled back its corporate lending exposure to $35 billion, less than one-fourth of the $130 billion in company loans that the lender and its predecessor companies had in 2000, the last time the Fed ended a series of rate increases, de Molina said.

``If you look at the amount of corporate credit risk that we have in this cycle versus the last cycle, it's much, much smaller,'' de Molina said.

An expanding economy allowed borrowers to tap banks for cash with little trouble even as the Fed was raising rates. The lending environment is still favorable for banks.

Debt deemed uncollectible by U.S. banks fell to 0.4 percent of all loans and leases in March, the least since before 1985, according to the Fed. Borrowers defaulted on high-yield, high- risk, or leveraged, loans at a 3.2 percent rate in the first quarter, down from 10 percent in 2002, according to S&P.

SunTrust's Loan

Atlanta-based SunTrust Banks Inc. was stuck with a non- performing $200 million loan because the borrower's business deteriorated before the bank had a chance to sell the loan to investors, said Richard Bove, who follows the bank for Punk Ziegel & Co. in Pinellas Park, Florida.

The loan was to ``a large corporate client whose operating fundamentals are deteriorating,'' SunTrust Chairman and Chief Executive Officer Phillip Humann said Aug. 14 during a presentation at Keefe, Bruyette & Woods Inc.'s bank conference in Kohler, Wisconsin. He declined to name the borrower, saying it was ``very legitimate company'' that lost a major customer.

SunTrust spokesman Barry Koling said the loss on the loan isn't connected to the economy. The bank is working with the company to try to recover the money, he said.

``SunTrust is definitely a bellwether,'' said Tanya Azarchs, managing director and coordinator of global research at S&P in New York. ``We're going to see a lot more of this.''