The hope is that by making mortgages and other loans cheaper, ultra-low rates eventually may revive economic growth, Bloomberg Businessweek reports in its Feb. 6 issue. For now they’re squeezing profits at banks and disrupting investment strategies at insurance companies and pension funds. They’ve reduced payouts on savings accounts and bonds, and may lead to higher bank fees and insurance premiums.
“For most people, there’s been more downside to these low rates than upside,” says Barry Ritholtz, chief executive officer of FusionIQ, a New York-based investment research firm. “They’ve punished savers and people living on fixed income, and made insurance more expensive.”
For banks, low rates provided a boost at first because they could borrow money cheaply and reduce rates paid to depositors while still collecting interest on existing loans made at higher rates.
As old loans matured, banks had to make new loans at lower rates, cutting into profit. At JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC), Citigroup Inc. (C) and Wells Fargo & Co. (WFC), the four largest U.S. banks by assets, net interest margins -- the difference between what they pay to borrow and what they earn on loans -- dropped to 2.99 percent in the fourth quarter from 3.17 percent a year earlier.
‘Margin Compression’
“There’s no best way to counteract net interest margin compression,” says Betsy Graseck, a Morgan Stanley (MS) analyst. “You need to have several different strategies.”
Many banks have announced cost-cutting plans, including layoffs and lower compensation. Jason Goldberg, a Barclays Capital analyst, says larger banks are increasing fees on deposit accounts and slashing debit-card rewards programs.
“There are certainly a lot of levers they are pulling,” Goldberg says. “That said, it’s a big challenge. For a lot of these banks the majority of their profits comes from net interest income.”
Low rates also present a special challenge to insurers, which need safe, predictable investment returns to pay claims. About 64 percent of the property and casualty insurance industry’s portfolio is in high-grade corporate bonds. The average yield on investment-grade corporate bonds has fallen to 4.3 percent, from 6.2 percent in July 2007, according to data compiled by Bloomberg.
Insurance Losses
Insurers suffered $32.6 billion in losses from January through September 2011 in the wake of natural disasters including Hurricane Irene and tornadoes in the Midwest. To make sure they have cash available, insurers have begun moving some of their money into shorter-term bonds, says Steven N. Weisbart, chief economist at the Insurance Information Institute. Since shorter-term bonds have lower yields, that shift leads to a further squeeze on investment income.
Data through the third quarter indicates that industry profits were down 60 percent from the same period in 2010. Weisbart says that to make up for lost investment revenue some insurers may begin tightening underwriting standards and raising premiums.
Like insurers, pension funds have long counted on bonds to help them meet future obligations. After four years of low rates, and a decade of flat performance in the stock market, corporate pension funds face record shortfalls. A January report by Credit Suisse Group AG estimated that 97 percent of companies in the Standard & Poor’s 500 have underfunded pension plans.
‘Dispiriting Year’
The combined deficit at the 100 largest defined-benefit plans increased by $236.4 billion last year, according to an annual pension study by Milliman Inc., a Seattle-based actuarial and consulting firm.
“This was an unusually dispiriting year,” wrote John W. Ehrhardt, a co-author of the report. Depressed interest rates were responsible for 90 percent of the funding shortfall accrued since the middle of 2011, Ehrhardt says. “It’s all about having to cope with low rates right now.”
To address the shortfalls, companies have been making record levels of cash contributions to their pension funds over the past year. Boeing Co. (BA) recently announced that it would contribute $1.5 billion to its pension plan in 2012.
Traditionally, pension funds followed a simple allocation rule of thumb, investing 60 percent of their money in stocks and 40 percent in bonds, according to Ehrhardt.
‘More Sophisticated’
“That was the answer for many years,’” he says. “Things have gotten much more sophisticated.”
The biggest change over the past decade has been the position pension funds have begun taking in alternative investments. Between 2006 and 2010 they doubled their exposure to riskier investments -- including real estate, private equity, and hedge funds -- to 20 percent, according to Milliman.
Lately, pension funds have been trying to boost yields by buying bonds with longer maturities. By lengthening the average maturity of their bond portfolios by about six to eight years, funds have been able to get about two percentage points of extra yield, says Ari Jacobs, a pension specialist at consulting firm Aon Hewitt. That strategy carries its own dangers: When interest rates rise, the value of existing bonds falls--and longer- maturity bonds drop more than shorter-maturity ones.
“The traditional tools to manage a portfolio, like time horizon and diversification, have been thrown out the window,” says Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago. “All the lessons my generation has learned over our lifetime have been seriously called into question these last few years.”
To contact the reporters on this story: Matthew Philips at mphilips3@bloomberg.net; Dakin Campbell in San Francisco at dcampbell27@bloomberg.net
To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net
http://www.bloomberg.com/news/2012-02-02/banks-pensions-are-squeezed-as-fed-s-low-rates-erode-profits.html
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