Net Interest Margins: Source of Economic Stimulus

The financial sector may finally be ready for a breakout, and the effects of an interest rate hike could be a source of economic stimulus

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The oft forgotten and abused financial sector may finally be ready for a breakout and the effects of an interest rate hike in September could possibly be a source of economic stimulus for the economy. It all comes down to net interest margins for the banks, the difference between the cost of capital and the income from interest received by other banks and debtors, a number greatly controlled by the Federal Funds rate. The higher this number rises, the more willing banks are going to be to form more traditional lending syndicates that help to finance small businesses and construction loans. The net interest margin is defined as; (Net Interest Income-Net Interest Expense)/Average Interest Earning Assets.

From a value perspective of investing, many would argue that the financial sector is the most undervalued sector in the economy. The price to book and price to earnings ratios for the 4 big banks as of Aug. 30, assessing their earnings and assets are as follows; Wells Fargo (WFC, Financial) P/B 1.4 P/E 12.28, Bank of America (BAC, Financial) P/B .67 P/E 13.36 , JP Morgan Chase (JPM, Financial) P/B 1.07 P/E 11.36 and Citi Bank (C, Financial) P/B .65 P/E 10.03 , all textbook Ben Graham numbers. However, similar to an individual that doesn’t want to sell its home when it is underwater, the banks are not going to logically want to raise capital by diluting equity of an undervalued security. In order to keep up with investor expectations in a flat or decreasing revenue environment and shrinking interest rate margins, banks have made some labor cuts to reduce expenses and maintain the bottom line.

With all that being said, the financial sector has done more than its part in job creation since the financial crisis as evidenced by the following chart by the United States Department of Labor (found here: http://data.bls.gov/timeseries/CES5500000001).

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The financial sector typically employed 8.4 million plus before the financial crisis, and we’re just now seeing those jobs return, with the economy being larger now than 2006, those jobs numbers have room to grow.

The financial sector is also one of the most logical ones from a balance sheet management point of view, for example, the annual treasury stock and retained earnings numbers for Wells Fargo for fiscal years 2013, 2014 and 2015:

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The number one rule in financial management and accounting courses from analyzing a company’s balance sheet is to make sure that retained earnings are increasing year over year (or are at least positive), check. But the treasury stock also tells us that the banks themselves feel they are undervalued and the most logical use of free cash flow is to buy back shares. This is great from an investor perspective that the amount of shares outstanding is decreasing, but if net interest margins increase for a bank with awesome cross selling capabilities like Wells Fargo, they will be encouraged to invest more in growing the business and employing more individuals rather than shrinking the business to keep up with forward eps expectations.

The insurance industry is also affected by interest rates from their ability to reinvest the float of premiums paid by customers. I encourage everyone to read a few Berkshire Hathaway (BRK.A,BRK.B) annual letters post Geico acquisition, as Warren Buffet does a masterful job of explaining the reinvestment of the float and why Berkshire is actually worth at least 25% more than its book value due to the capital it can invest from its insurance operations that have to be recorded as liabilities on the company’s balance sheet according to GAAP, but are actually assets to a company when used correctly.

The other interesting thing about insurance operations held by holdings companies like Berkshire Hathaway, is that the income generated by the float is usually reinvested in other operations that range from large publicly listed companies, to small privately owned companies within the holding company. Again, another economic plus for net interest margin increases in relation to job creation.

Finally, harkening back to a previous article regarding free wheeling debt usage by large corporations, increasing the risk free rate by way of rate increases will force companies into more and more profitable decisions that usually mean more jobs being created in traditional investments that have been proven.

We’ll see in September.

Disclosure: The author is long WFC, BAC, BRK, and JPM. The author holds no position in Citi.

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