September 28, 2010 by DAVID REILLY

The financial-services industry is built for speed. But while superlow interest rates are meant to be high-octane fuel for the economy, they are gumming up financial engines.

 

 

The problem for many banks, insurers and fund managers is that their cost of borrowing can’t fall below zero. Yet returns from a number of businesses or products continue to decline with already near-record low bond yields. That compresses margins and threatens to make some business lines uneconomic.

 

 

While firms have dealt with falling yields for 30 years, this is the first time they have faced a zero floor on borrowing costs. Adding to the painful mix, the pressure on margins comes at a time of tighter regulation and a moribund economy.

 

 

Signs of angst are emerging. One senior investment banker recently talked in private of rock-bottom rates “decimating” the business if they continue for a number of years. No wonder there is talk of layoffs on Wall Street.

 

 

During Northern Trust’s second-quarter earnings call, Chief Financial Officer Bill Morrison said that “the extremely low interest-rate environment reduced second-quarter revenues by about $70 million when compared with historical averages.” He added that low rates “mean that our money-market mutual funds cannot generate sufficient yield to cover the management fees.”

 

 

Insurers have similar concerns. “A prolonged period of historically low rates is not healthy for our business fundamentals,” Lincoln National Chief Financial Officer Fred Crawford said on his firm’s second-quarter call.

 

 

That is another reason why the Federal Reserve is so keen to avoid deflation setting in and is considering a return to large-scale money printing.

 

 

Persistently low rates could force firms to rethink or even exit from businesses. Consider fixed-rate annuities and life-insurance products that offer a guaranteed minimum payout. If an insurer didn’t match that liability when products were sold with assets that generate similar income, losses could ensue.

 

 

While firms usually hedge much of that risk, they also face the prospect of declining business for some new products offering lower guaranteed payouts. Sales of fixed-rated, deferred annuities, for example, fell 45% in the second quarter of 2010 from the same period a year earlier, according to insurance-industry group Limra.

 

 

Insurers can also expect to generate lower income from their huge investment portfolios. Analysts at Keefe, Bruyette & Woods estimated that U.S. life insurers could see a 2% reduction in 2011 earnings and 4% in 2012 if yields stay at currently low levels.

 

 

Banks, too, are feeling the pinch. Many have set deposit rates close to zero and have converted high-yielding certificates of deposit to lower rates. That gives them less room to cut funding costs. The amount they can earn from lending or investing, though, is under continued pressure, shrinking banks’ net interest margins.

 

If rates stay at current levels, U.S. regional banks are likely to see net interest margins decline from an average of about 3.54 percentage points in the third quarter to about 3.44 percentage points this time next year, according to Craig Siegenthaler, a Credit Suisse bank analyst. That compares with margins well above four percentage points before the crisis.

 

 

Brokers such as Charles Schwab and TD Ameritrade Holding; banks with big brokerage or asset-management operations, such as Bank of America and Morgan Stanley, and trust banks such as Northern Trust and State Street face threats, notes Sanford C. Bernstein analyst Brad Hintz. One is the greatly reduced returns firms can generate from cash in so-called sweep accounts that hold customer funds between trades, as well as money-market accounts. Another is the falloff in securities lending margins and activity.

 

 

So while low rates may be seen as a panacea for the economy, they could prove to be a form of Chinese water torture for plenty of financial firms.

 

 

Write to David Reilly at david.reilly@wsj.com

 

Source: Proshare