Banks That Will Benefit the Most From Rising Interest Rates

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NEW YORK ( TheStreet) -- The Federal Reserve is unlikely to stop priming the economic pump any time soon, and that's critical for bank-stock investors.

With historically low short-term interest rates pressuring earnings at regional banks, and mortgage spreads appearing to have crested, investors can expect banks in 2013 to sharpen their focus on cutting expenses.

Bernstein Research on Thursday downgraded four regional banks to "underperform." On the other hand, Jefferies analyst Ken Usdin provided some hope for long-term investors who expect a big jump in rates over the next two years.

Margin Pressure and Mortgage Pressure


The central bank has kept the short-term federal funds rate in a target range of zero to 0.25% since late 2008, and the Federal Reserve Open Market Committee on Wednesday said it would continue its purchases of $85 billion a month in long-term securities. Last year this expansion of the Fed's balance sheet was tempered through the sale of $45 billion a month in shorter-term U.S. Treasuries, but those sales have ended. The Open Market Committee has also said that the "exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6.5%," assuming that inflation is kept in check.

A bank's net interest margin (NIM) is the spread between the average yield on loans and securities investments and the average cost for deposits and borrowing. With most banks already realizing most of the benefit on the cost side, margins are getting squeezed as assets continue to reprice at lower rates. Still, many regional banks have been successful in tempering the blow to net interest income by boosting commercial loan portfolios.

Usdin said in a report late Wednesday that "we feel better about estimate sustainability (particularly for larger regionals), but struggle to find much EPS growth through 2014." The analyst noted that for the regional banks covered by his firm, total loans grew 2% sequentially during the fourth quarter, as commercial and industrial lending "ended the year on a high note." Still, he said few investors were "willing to believe it."

"We attribute some of the strength to tax planning and are therefore hesitant to revise our loan growth estimates meaningfully higher," he said.

According to Usdin, NIM compression "has made it tough to grow net interest income, even with better-than-expected loan growth." With the yield on 10-year U.S. Treasury bonds rising to over 2% from 1.62% two months ago, Usdin said the "steepening of the yield curve will help limit NIM downside."

Mortgage banking revenue has also been a source of strength for regional banks over the past year, but the rise in 10-year yield has narrowed the spread between mortgage loan rates and the yields on mortgage-backed securities. This means lower gains for banks on the sale of newly originated mortgage loans to government-sponsored enterprises, including Fannie Mae and Freddie Mac. Usdin said "a retreat to 2011 margins would drive a 30%-40% decline in production revenue even if origination volumes hold flat."

A "Rate Trade"


So where's the silver lining for investors? Usdin said that with the rise in the yield on 10-year Treasuries, "bank stocks are moving again in anticipation of higher rates."