Fed could slow bank recovery

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NEW YORK (CNNMoney.com) -- The Federal Reserve's latest program to buy massive amounts of government debt could provide a helping hand to the economy - but not so much for bankers.

Treasury prices rallied sharply Wednesday after the central bank revealed plans to purchase $300 billion in long-term debt over the next six months. But it also sent corresponding yields plummeting.

The yield on the benchmark 10-year note, for example, suffered its biggest single-day decline in more than 20 years. Rates on shorter-term debt fell in tandem on the news, but to a much smaller degree. (Bond prices and yields move in opposite directions.)

That is troubling for banks, which typically borrow money at short-term interest rates and make long-term loans.

"Normally banks do well when the yield curve is steep," said Gerald Hanweck, a finance professor at George Mason University's School of Management.

At a time when banks face numerous headwinds -- including rising loan losses and ongoing weaknesses in the housing market -- the gap between long and short term rates, or the slope of the so-called "yield curve", has been one of the few bright spots for banks lately.

Last quarter, a period of severe strain for the industry, banks generated about $97 billion in profits from the money they took in and lent back out. That's up 4.9% from $92.5 billion during the same period a year ago, according to the latest industry reading by the Federal Deposit Insurance Corp.

What got rates to this level in the first place was the Fed's aggressive rate-cutting campaign, which accelerated as the financial crisis gathered momentum last fall.

Many analysts believed that the steepness of the yield curve would allow those banks that were not completely overwhelmed with bad loans or toxic securities to earn their way out the crisis. But now those hopes appear to be diminishing.

"It could backfire a little on the Fed by weakening bank earnings which aren't that strong to begin with," said Hanweck.

Details remain scant about the Fed's Treasury buying program, although the Federal Reserve Bank of New York indicated earlier this week that the purchases would focus on Treasurys with two- and five-year maturities.

What may vex bankers further is the length of the program. Purchases are expected to take place 2 to 3 times per week on average for the next six months.

"The Fed has definitely put a cap on interest rates," said Mary Ann Hurley, vice president of fixed income trading at D.A. Davidson in Seattle.

Certainly, the program has its benefits. By buying government bonds, the Fed hopes it can bring down interest rates on a wide variety of debt, including mortgages. To that end, the Fed also said Wednesday it would buy $750 billion's worth more of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac.

If these efforts help lead to even lower mortgage rates, it could coax many potential homebuyers back into the market or spark a rash of refinancing activity. That stronger loan volume, notes Jennifer Thompson, senior analyst at the New York-based financial services research firm Portales Partners, would help compensate for any premium lost as a result of a flattening yield curve.

"For the banks that are big mortgage originators, the move in the 10-year [Treasury] would be the most impactful," she said.

Still, some experts fear that the program could work to the disadvantage of many smaller lenders, which make up the lion's share of the more than 8,300 institutions that populate the nation's banking industry.

Unlike their larger peers, community banks have largely been shut out of many of the government programs aimed at salvaging the banking sector and alleviating the credit crunch.

Hanweck notes that many smaller banks cannot access the Federal Reserve's Term Asset-Backed Securities Loan Facility, or TALF, to make a loan on the cheap.

"The top 20 [banks] have borrowing advantages that the smaller ones just don't have," he said.