Why “Zero” is a Four-Letter Word for Financial Stocks
As the stock market dissolves into coronavirus chaos, three of the hardest-hit sectors have been energy, transports, and financials.
The pain in energy and transports is relatively simple to understand. Crude oil prices have collapsed, wreaking havoc on anything fossil-fuel related. Travel and shipping demand has also collapsed, due to contagion fears and supply-chain disruptions, respectively.
But what about financial stocks?
For banks and other lenders, the pain revolves around “zero” — as in zero interest rates and zero growth.
Zero interest rates, let alone negative ones, are not supposed to be a thing in the business world. When interest rates go to zero, all kinds of calculations go haywire.
For example, consider this old economist joke: At a zero interest rate, you could justify paving the Rocky Mountains to save money on gas.
The project would cost trillions, but at a zero rate of interest there is no time pressure — you have an infinite window of time to pay back the funds, and an infinite window of time to reap a net return on investment.
The point, of course, is not that paving the Rocky Mountains makes sense; it’s that zero interest rates lead to screwy calculations. When capital costs nothing, virtually any capital expenditure can be justified.
This is why, when rates hang around zero, terrible projects tend to get funded. While the actual lending rates aren’t zero, the projects become more risky and nutty as the cost of capital falls.
And then, when something unexpected goes wrong, the lenders are often left holding the bag.
This is happening with energy now, as bad or foolish loans to the shale industry are coming back to bite the banks. Prior to the recent oil price collapse, there was already a huge volume of energy sector debt hovering on the brink of insolvency and default; now it will be pushed over the edge.
The phenomenon of long-term interest rates headed toward zero is also bad news for the banks.
The entire banking industry runs on “net interest margin,” or NIM. This is the profit spread created by borrowing at a low rate and lending at a higher rate.
When a bank pays a 2% rate on customer deposits, it is effectively “borrowing” that money from depositors at 2%. If the bank then averages 4% on its loan book, the difference between the 2% and the 4% is how the bank makes money.
Most all of the bank infrastructure we see — the physical bank branches, the giant vaults, the downtown skyscrapers, the high-paid executives — is paid for by NIM.
This is why bankers prefer to see interest rates rising rather than falling. The higher the average level of interest rates, the larger the NIM spread that banks can collect.
When interest rates fall sharply, however, the banks face a double whammy of bad news. First, as interest rates head toward zero, the NIM spread gets compressed, which reduces bank profit margins.
And second, if the falling rates indicate a downturn — a move toward zero or negative economic growth — the banks can expect more problems with their loan book, in the form of reduced business and a higher rate of borrower defaults.
In the past few days, the U.S. 10-year treasury note and the 30-year long bond have fallen to new record lows. The 30-year treasury yield even fell below 1% for the first time in history.
This is bad news for the banks on multiple fronts: Profit margins are falling (via compressed NIM spreads), future lending is likely to slow (via slow or absent economic growth), and present default rates are likely to rise (as risky borrowers run into trouble).
This is why, for bankers at least, “zero” is a four-letter word. For current and future U.S. homeowners, a small silver lining is the fact that mortgage rates are hitting all-time lows.
Then, too, Federal Reserve watchers see interest rates falling even lower.
Jeffrey Gundlach, arguably the most successful bond fund manager on Wall Street, has noted that, when the Fed cuts 50 basis points, they usually cut again in short order. He sees another 50-basis-point cut at the Fed’s next two-day meeting on March 17 and 18.
If he is right, financial stocks likely haven’t found their floor.