NEW YORK (CNN/Money) - Business was swell in the second quarter for the nation's banks, but in the third quarter they could run into third-act problems.
Banks have handily beaten Wall Street estimates. Citigroup, the biggest, reported a second-quarter profit of 80 cents a share, three cents ahead of forecasts. Number two, J.P. Morgan, came in at 89 cents versus expectations of 62 cents. Bank of America -- the third largest -- earned $1.80 against an estimate of $1.57. And so on.
What was the secret to the banks' success? Partly, it was because, for the first time in a long time, they're not seeing their loan portfolios hit by things like Enron, WorldCom and Argentina. But mostly it was because they reaped huge benefits from bargain basement interest rates. Unfortunately, it looks like these benefits are going away.
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Their methods may be a little bit more refined, but banks' most basic business doesn't differ all that much from your local loan shark's: They lend out money at a higher rate than they have to borrow it at and the difference between the two (minus the losses from the occasional deadbeat) is profit. Your loan shark probably gets his money from various other business interests in your neighborhood (your bookie, say); your bank gets its money from you, the depositor.
Banking on low rates
With the Fed's cutting of the overnight funds rate to 1 percent, banks aren't paying depositors very much at all these days -- less than half a percent if we're talking about a savings account. But despite those slim pickings, households have continued to stuff their money into banks.
"A lot of the banks have been able to grow their deposits very nicely," said Kevin Callahan, an analyst with Century Shares Trust. "That was partly due to all of us being too scared to put our money in the stock market, or the bond market for that matter."
It was a nice source of cheap capital for the banks, who were able to put it to work in their credit card and mortgage businesses or simply to finance purchases of higher yielding financial instruments like the tradable baskets of mortgage loans known as mortgage-backed securities.
But now, thinks Callahan, with the stock market doing better people may decide that savings accounts aren't as good a place for them to put their cash and banks could lose an important source of funding.
Headwinds
Even more damaging to banks' prospects is the selloff in the bond market. With the 10-year Treasury's yield lifting in a little more than a month from its June low of 3.11 percent to the current 3.94 percent, mortgage rates, too, are rising and it may be that the huge boom in mortgage activity has come to an end.
That hurts in a couple of ways. First, points out Brett Gallagher, head of U.S. equities at Zurich-based investment firm Julius Baer, one of the reasons deposits have been able to grow so much is that households were socking away a portion of the money that they raised through mortgage refinancing.
The other way it hurts is that many of the banks, seeking out higher yields, have been heavily buying up mortgage-backed securities -- at the end of June the amount of mortgage-backeds in bank portfolios had risen by 43 percent from a year ago, according to the Fed. That was a great trade while rates were falling, but it's beginning to look dangerous. One bank, North Fork, was wary enough of what a rise in rates can do that in late June it announced that it was significantly reducing its mortgage-backed portfolio. But other banks have yet to give any indication that they're following North Fork's lead.
Even if banks don't run into any trouble in mortgages, said CreditSights analyst David Hendler, they are going to need to find a new way to make money. The hope is that as the economy improves, their other businesses, like commercial loans and investment banking, take up the slack. In a rising rate environment, however, that may be a challenge.
"When rates rise, it's just difficult to make money," Hendler said. "It's going to be hard on a lot of players."
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