December 8, 2021

Inflation and Rising Interest Rates Shrink Yield Spreads, Raising Risks for Financial Institutions

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Banks and credit unions face a yield spread squeeze as persistent inflation appears likely to push the Fed into interest rate increases sooner, rather than later.

The current environment appears to be eerily similar to the inflationary period in the early 1980s that caused the savings and loan crisis, the worst crisis to hit the financial industry since the Great Depression. Banks and credit unions would be wise to take a lesson from this dark period in the financial sector and adjust now for rising interest rates.

Persistent Inflation Will Push Fed’s Hand

A short spurt of inflating consumer prices was expected as the economy bounced back quickly from the pandemic-induced recession, but the numbers continue to look sketchy as supply-chain issues drag on. Rather than easing as the recovery progresses, the Consumer Price Index rose by 6.2 percent in October, its sharpest increase since 1990, according to The New York Times. Excluding the volatile food and fuel numbers, the increase still stood at 4.6 percent, well above the Fed's targeted 2 percent inflation. October's bump was also a 0.9 percent spike over September, which had seen a 0.4 percent increase.

One factor in this month's report that concerned economists are that rent was a significant factor in the jump. The concern stems from the fact that once rent starts to go up, it does not come back down quickly.

The first step we're likely to see from the Fed is to ease off on its bond-buying program, which has helped keep interest rates at rock bottom and money flowing. The Fed has been buying $120 billion in bonds each month, and minutes from its October meeting indicated they could start scaling that back as early as December. This will put upward pressure on interest rates before the Fed actually begins to hike its rates, which had been expected to happen by mid-2022.

A review of recent interest rates shows that despite the Fed funds and prime rates remaining steady over the past year, U.S. Treasuries and swap rates have been creeping higher, especially on longer-term loans. This would indicate rates are primed to rise at even the slightest encouragement from the Fed.

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How Lenders Could Get Caught in a 1980s Trap

A look back over the past three decades could show us the current risk, especially for smaller banks and credit unions that have loaded up on low-interest, long-duration home mortgages.

The S&L crisis began its slow development in the late 1970s/early 1980s when S&Ls were limited by federal law on the interest rates they could charge on loans and pay on deposits. As interest rates climbed in the early 1980s to battle inflation, S&Ls were left with little loan business but low-interest rate home mortgages and fewer deposits as banks siphoned away customers with higher-earning money market accounts.

The 1982 Garn-St. Germain Depository Institutions Act eliminated loan-to-value ratios and interest rate caps for savings and loans and allowed them to hold 40 percent of their assets in commercial loans and 30 percent in consumer loans. But S&L deposits still were protected under the Federal Savings and Loan Insurance Corporation.

This offer of reward with little risk fueled a strategy where the S&Ls pursued riskier commercial investments and even riskier junk bond deals. Some even wound up participating in fraudulent real estate deals. All of which led to a massive $160 billion bailout, including $132 billion in taxpayer funds. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) again re-imposed restrictions on S&L activities and set up the Resolution Trust Corporation, which ultimately liquidated 700 S&Ls. By 1989, more than 1,000 S&Ls across the country had failed.

Though regulators are unlikely to free up banks and credit unions to duplicate the Wild West days that led to the S&L crisis, that initial pressure of a portfolio heavy on low-interest, long-duration home mortgages looms, particularly if inflation remains problematic and the Fed moves more quickly to increase interest rates and at a faster pace than previously expected.

Preparing for Rising Interest Rates

As banks and credit unions waded through this sluggish season in the loan market with increased deposits sitting on the books, much of the activity surrounded new mortgage loans and refinancing. This emphasis may have shifted the loan portfolios for some institutions out of balance, with a heavy percentage of these low-interest mortgages that will be on the books for the next 15 to 30 years.

As banks and credit unions are forced to pay out higher interest rates on deposits, they will need to gain higher-returning loans or investments to offset that tightening yield spread.

American Banker reported community banks are seeing some relief as rising consumer demands are fueling a desire for business growth. Many smaller banks are reporting a strong pipeline that indicates business and commercial real estate loans could be strong well into 2022. However, prospects were not strong across the board. For banks with assets under $10 billion, commercial and industrial loans were down 13.7 percent from a year earlier and 10.1 percent from the previous quarter.

Banks and credit unions will need to continue to seek organic ways to maintain diversity in their loan portfolios and offset low-yielding home mortgage loans. National Bank Holdings in Denver reported to American Banker that it generated a quarterly record of $413 million in the third quarter, fueled by $302 million in commercial loans in a footprint that spans Colorado and four surrounding western states.

Banks and credit unions that cannot match that type of organic growth in their regions need to explore other high-yield but safe options to maintain a diverse loan portfolio.

Garnet Capital can help these institutions acquire short-term, higher-rate, high-quality consumer loans that can absorb the threat of rising interest rates. Garnet Capital also has superior-quality commercial loans available for purchase. As institutions plan how to adapt to this changing yield landscape, they can contact our expert staff to purchase loan portfolios that will meet their diversity needs while matching the types of loans they are comfortable owning.