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Kevin Kersten's Analyst Insights

InvestorsObserver
Options Analyst Writer
Kevin Kersten
Author Bio


July 15, 2013 - Banking on Interest Rates?

As the Federal Reserve looks to slow the monthly $85 billion dollar bond buying program, it appears that higher interest rates are just around the corner. This will be a change for investors and banks that have grown accustomed to cheap money.

Although banks have tightened regulations on who can get money, those with good credit have never been able to get money as cheaply as they can today. Interest rates are still near all time lows and the years of federal printing of money may be coming to an end. The Fed is targeting an unemployment rate of 6.5% before raising rates, but it will let up on the bond buying well before then.

It may well be time to raise interest rates, holding them artificially low for so long has consequences. The real estate bubble and the US subprime loan crisis were in part caused keeping rates artificially low for too long. Low interest rates allowed buyers to afford more expensive houses and bid prices up higher than they should have. Interest rates affect a lot of factors through society from the cost of housing to returns on investment income for those in retirement. While low interest rates may make it more affordable for a newlywed couple to buy their dream house, it can cause their elderly parents financial hardships as investments underperform prior expectations.

 

Banks are on both ends of the spectrum, as they pay out interest on deposits (something they have gotten for almost free recently) but also charge interest on loans. Banks do loan out a lot more than they take in, and the interest rates on loans are higher than those on deposits, so higher interest rates could be a net positive.

Stock markets can also be fueled by a lot of cheap money. Investor who can't get good returns in banks go into bonds or equities in hopes of better returns. Unable to get returns in banks investors buy dividend paying stocks on margin and try to get higher returns. Risks of leveraged money are well known, but trading commissions can also add to the bottom line of bank performances.

Interest rates are more complicated for banks as there are both long and short term rates. If they both rise and fall together the impact will be less, but if long term rates rise and short term do not, banks could feel more pressure.

There are both positives and negatives of higher interest rates. Generally, though it would seem as if banks should do better as interest rates rise. Rates have been extremely low, and larger margins will be possible as they rise. Generally, improving business conditions will also be good for banks as businesses recover from the protracted sluggishness. Merger and acquisition activity could also speed-up as business improves.

Morgan Stanley (MS) is one of the big investment banks. It employs 57,000 people and has an S&P four STARS stock rating. The stock saw some earnings difficulties last year, but analysts are looking for a turnaround. In 2010 the company pulled in $2.44 per share, in 2011 the company pulled in $1.26 per share and in the 2012 it lost $0.04 per share. The trend seems to be broken in the first quarter of 2013 with earnings of $0.50 and expectations for earnings in that range for the rest of the year. Weak client activity led to the 19% revenue decline last year, but this year 24% growth is expected as it bounces back. The company has been reducing compensation, and is expected to see savings as systems are integrated into one platform. Of course, regulations, trading activity and interest rates can all be hard to predict.

Take a look at a covered call on Morgan Stanley (MS). With the stock trading at $25.34 the 25 October covered call is selling for $1.89, which means the covered call has 7.5% of downside protection and a 6.6% assigned return over the next 101 days. That's a 24% annualized return rate (for comparison purposes only). The stock pays a dividend yield of 0.81% as well. Rising interest rates could lift banks, but such moves will be not be fast or sharp. Investors could well try to take advantage of such moves through a covered call bringing the extra premium in as cash.

Chart courtesy of stockcharts.com

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