December 12, 2005
Squeeze play | Maine bankers look back at the tight interest rate environment of 2005, and look ahead to 2006
By Sean Donahue
After a giddy couple of years featuring record-low interest rates, 2005 will likely be remembered by consumers, businesses and the banks that serve them as a sobering year. In this case, the black coffee came in the form of steadily rising interest rates, which meant consumers paid more for their variable-rate loans and saw the rate on 30-year mortgages jump back above six percent. For banks in Maine and across the country, though, the issue wasn't just that interest rates were rising ˆ it's that some interest rates were rising a lot faster than others.
Throughout 2005, the Federal Reserve Board has been steadily hiking the Fed Funds Rate, which banks use as a benchmark for setting their own interest rates on short-term deposits such as money market accounts and CDs. In the beginning of the year, the Fed Funds Rate stood at 2.25%. But after seven consecutive boosts this year to ward off inflation, that rate in the beginning of December was four percent. At the same time, though, long-term interest rates have barely budged. The yield on a 10-year U.S. Treasury Bond, which is the benchmark for 30-year fixed-rate mortgages, has only risen from 4.23% to 4.49% ˆ barely more than a quarter of a percentage point.
The result is what bankers, economists and investors call a flat yield curve, which means that banks are having to pay higher interest rates on products like CDs and money market accounts, while receiving only slightly higher interest payments from their loan customers. For example, the nationwide average rate on a one-year CD has risen from 1.74% to 2.76% so far this year, according to Bankrate.com. In the same period, the average rate charged for a 30-year mortgage has increased by just over half a percentage point, rising from 5.81% to 6.36%.
With that shrinking spread, banks face potential tightening of a key engine of their own profits known as the net interest margin, the difference between what the institution pays out to depositors and what it receives from borrowers. So far, most Maine banks have appeared to weather the rising rate environment without significant impact on their net interest margins, according to the most recent data from the Federal Deposit Insurance Corp., which shows the average NIM in Maine at 3.77%, compared with 3.76% a year earlier.
To maintain that NIM, though, bank executives have to carefully manage both their product mix and their balance sheet. Hoping to learn how banks have done that in the rising-rate environment, Mainebiz checked in with four banks across the state to hear their take on 2005 ˆ which they all described as a "challenging" year ˆ as well as their outlook for interest rates in 2006.
Dan Hunter
Chief financial officer and chief operating officer, Gorham Savings Bank
Like most bankers, Dan Hunter says the most significant market factor affecting Gorham Savings this year was the "unbelievably flat" yield curve. One of the impacts, he says, was a shift in customer demand for key products.
Customers who flocked to capitalize on their home equity in the past few years have seen their interest payments jump in 2005, since most home-equity loans have variable interest rates based on the prime rate. With that rate at seven percent these days ˆ up from five percent a year ago ˆ Hunter says the bank is already seeing customers coming back to refinance those loans in an attempt to lock in a rate.
On the deposit side, though, customers still resist tying up their money at fixed rates, he says. Hunter says customers are most attracted to shorter-term products such as one-year CDs. In response to that environment, Gorham Savings introduced a new product this year called a tiered NOW account, which offers 3.5% interest on deposits of more than $50,000. "That gave people a decent return on their deposit without locking that money up for a long time," says Hunter.
Attempting to guess where interest rates are headed in 2006 is especially difficult this year, Hunter says, because of the flat yield curve. He says bankers can make equally convincing arguments for rising long-term rates or falling ones ˆ which could either normalize the yield curve or tighten it even further. In the next few months, though, Hunter expects short-term rates to continue to rise, because most investors and economists expect the Federal Reserve Board to raise rates one to three more times. "The new Fed Chairman [Ben Bernanke] has to raise rates once just to show the markets he's willing to do it, but then he could be done," says Hunter.
In that environment, Gorham Savings will work to protect its net interest margin ˆ which is 2.85% today, compared to 3.15% at the same time last year ˆ or boost income elsewhere if net interest income shrinks, says Hunter. One method of maintaining profits amidst tightening margins is increasing the volume of loans the bank writes or deposits it takes in. That's not easily done, though, given the competitive Maine banking landscape, especially in the greater Portland area. "You have too many banks chasing too few customers in the marketplace," says Hunter.
In response, Gorham Savings plans to use new products and marketing efforts to attract and retain business, and if necessary resort to other financial resources to protect itself from interest rate risk. For example, to fund a large volume of fixed-rate mortgages, the bank could turn to the Federal Home Loan Bank, which loans banks money at a fixed rate lower than what the banks charge borrowers. "But our first preference for funding is always from serving customers," says Hunter. "That's what we're in business for."
Peter St. John
Senior vice president, commercial services, Katahdin Trust Company, Patten
Forestry and logging-related businesses represent the largest customer base for Katahdin Trust's commercial loan division. But that business has been slowing this year, says Peter St. John, thanks to the impact of rising rates. Last year, the bank's loan portfolio grew 17%. Through November of this year, he says, that growth rate is about 8.5%.
For starters, St. John says, customers in northern Maine have been deferring plans for equipment purchases or expansion due to rising rates. And many customers with variable-rate loans ˆ the kind that would help the bank maintain its net interest margin if short-term rates continue to rise ˆ have been coming back throughout the year to convert to fixed-rate options. "It's the catch-22 for both customers and the bank to find pricing that is acceptable to both parties," he says.
St. John expects the Fed to raise short-term rates once or twice more in the coming months, but does not expect long-term rates to rise along with them in early 2006. That means an even flatter yield curve.
To protect its net interest margin, the bank is working to attract customers to shorter-term fixed rates, such as three-year commercial loans instead of five-year, or to entice them to consider variable-rate options, according to St. John. Many commercial borrowers take out 10-year loans for cash-flow purposes, even though their business plan calls for paying off the loan in a shorter time period, says St. John. For those customers, the bank is offering combination fixed- and variable-rate options that might make shorter-term loans more attractive.
Looking ahead to next year, the bank is also working to attract or maintain large borrowers through what he calls "match funding." To provide a $1 million loan with a fixed rate, for example, the bank might borrow that $1 million from the Federal Home Loan Bank, receiving a fixed rate of its own. Then, it would write a loan to the customer at a slightly higher fixed rate, giving the bank a protected margin, provided that the customer agrees to FHLB terms such as restrictions on pre-payment.
St. John, however, is not overly concerned about the bank's ability to manage its balance sheet. Instead, he is worried about the broader impact on the northern Maine economy. The combination of high interest rates, high energy costs and potential insurance premium spikes after the southern hurricanes this summer and fall has St. John concerned that his business customers might have a very tough winter ahead of them. "From our bank's standpoint, to remain healthy and have a good year, customers are the backbone," St. John says.
Greg Dufour
President and chief operating officer,Camden National Bank
Greg Dufour says Camden National began anticipating rising rates as far back as the end of 2004, and has been positioning itself to that deal with that environment.
The bank's investment portfolio was one area it looked to for protection. Around the beginning of the year, the bank began boosting its investments in 12-month to 18-month bonds, instead of three-year or four-year investments. "So as rates were rising over that 12-month period, we were having those investments mature and that money available to invest at higher rates," says Dufour.
Dufour expects the flat yield curve to remain in place through early 2006, which likely means market conditions will be similar to those in 2005. Like other banks, Camden National is seeing growing consumer demand for fixed-rate loans combined with pressure to pay more interest on customer deposits. And like other banks, Camden National is finding it hard to fight that smaller gap between what it takes in from loans and pays out on deposits. "We don't have a lot of pricing power here," he says of the Maine banking market. "Quite frankly, that's not where we try to compete."
Instead, the bank's strategy is to attract customers by touting benefits other than interest rates. Dufour says Camden National is developing a new checking account that includes features he describes as "relationship based," such as a bundle of services that include electronic statements and online bill paying. Camden National also tries to keep a local-bank feel in all its branches through strategies such as letting individual branch managers set CD rates based local competition.
If rates continue to rise in 2006, he says, the bank will continue to tweak that combination of investments, products and marketing strategies. "It's always kind of a balancing act banks go through in changing interest-rate environments," says Dufour.
Rob Johnson & Jim Delamater
Chief financial officer and chief executive officer, Northeast Bank, Lewiston
While the flat yield curve is putting pressure on all banks, Northeast says it has still managed to increase its net interest margin so far this year, boosting it to 3.43% from 3.37% in December of 2004. CFO Rob Johnson credits that increase to the bank's "asset-sensitive" position, which is banking-speak to describe a portfolio in which loans ˆ called assets ˆ reprice faster than deposits, also known as liabilities.
That position has helped Northeast take in more interest income while delaying some of the higher interest payments it will have to make to depositors given the steady rise in short-term rates this year. At the end of November, Northeast was paying 4.25% on a one-year CD, compared to the 2.65% rate it offered in the beginning of 2005.
Still, CEO Delamater says, the flat yield curve is working against Northeast as it is most banks, since customers are now largely seeking fixed-rate loans at a time when the bank wants to maintain flexibility on what it charges customers to borrow. "One of the unique challenges banks face is that customers always want the opposite of what's good for us," says Delamater.
One way to continue meeting customers' demands while protecting the bank's finances is to sell fixed-rate loans on the so-called secondary market, where institutions buy loans to package into mortgage-backed securities. The secondary market for home mortgages had been booming a couple years ago, but is now falling off, says Johnson. In its 2005 fiscal year, the bank recorded $233,000 from mortgage sales, compared to about $1 million in fiscal year 2003.
Instead, though, the bank is finding a strong secondary market for commercial loans. Buyers such as insurance companies, mutual funds and real estate investment trusts are eager to buy commercial real estate loans, which they repackage into commercial mortgage-backed securities. "In this climate, the secondary market is willing to do something banks fundamentally don't want to do," Delamater says, referring to that market's willingness to hold on to fixed-rate loans. "That creates more demand and more sales in that area."
Like everyone interviewed for this story, Delamater and Johnson expect short-term rates to continue their rise in 2006. That means the bank will continue watching its mix of loans and deposits and looking to fees from non-banking businesses, such as an insurance agency it bought in 2004, to offset any declines in interest income.
But for Delamater, the more interesting question for 2006 surrounds the fate of long-term interest rates. "What we're all watching for is if the public can get confidence in the economy and the dollar, which would drive long-term rates up," says Delamater.
Throughout 2005, the Federal Reserve Board has been steadily hiking the Fed Funds Rate, which banks use as a benchmark for setting their own interest rates on short-term deposits such as money market accounts and CDs. In the beginning of the year, the Fed Funds Rate stood at 2.25%. But after seven consecutive boosts this year to ward off inflation, that rate in the beginning of December was four percent. At the same time, though, long-term interest rates have barely budged. The yield on a 10-year U.S. Treasury Bond, which is the benchmark for 30-year fixed-rate mortgages, has only risen from 4.23% to 4.49% ˆ barely more than a quarter of a percentage point.
The result is what bankers, economists and investors call a flat yield curve, which means that banks are having to pay higher interest rates on products like CDs and money market accounts, while receiving only slightly higher interest payments from their loan customers. For example, the nationwide average rate on a one-year CD has risen from 1.74% to 2.76% so far this year, according to Bankrate.com. In the same period, the average rate charged for a 30-year mortgage has increased by just over half a percentage point, rising from 5.81% to 6.36%.
With that shrinking spread, banks face potential tightening of a key engine of their own profits known as the net interest margin, the difference between what the institution pays out to depositors and what it receives from borrowers. So far, most Maine banks have appeared to weather the rising rate environment without significant impact on their net interest margins, according to the most recent data from the Federal Deposit Insurance Corp., which shows the average NIM in Maine at 3.77%, compared with 3.76% a year earlier.
To maintain that NIM, though, bank executives have to carefully manage both their product mix and their balance sheet. Hoping to learn how banks have done that in the rising-rate environment, Mainebiz checked in with four banks across the state to hear their take on 2005 ˆ which they all described as a "challenging" year ˆ as well as their outlook for interest rates in 2006.
Dan Hunter
Chief financial officer and chief operating officer, Gorham Savings Bank
Like most bankers, Dan Hunter says the most significant market factor affecting Gorham Savings this year was the "unbelievably flat" yield curve. One of the impacts, he says, was a shift in customer demand for key products.
Customers who flocked to capitalize on their home equity in the past few years have seen their interest payments jump in 2005, since most home-equity loans have variable interest rates based on the prime rate. With that rate at seven percent these days ˆ up from five percent a year ago ˆ Hunter says the bank is already seeing customers coming back to refinance those loans in an attempt to lock in a rate.
On the deposit side, though, customers still resist tying up their money at fixed rates, he says. Hunter says customers are most attracted to shorter-term products such as one-year CDs. In response to that environment, Gorham Savings introduced a new product this year called a tiered NOW account, which offers 3.5% interest on deposits of more than $50,000. "That gave people a decent return on their deposit without locking that money up for a long time," says Hunter.
Attempting to guess where interest rates are headed in 2006 is especially difficult this year, Hunter says, because of the flat yield curve. He says bankers can make equally convincing arguments for rising long-term rates or falling ones ˆ which could either normalize the yield curve or tighten it even further. In the next few months, though, Hunter expects short-term rates to continue to rise, because most investors and economists expect the Federal Reserve Board to raise rates one to three more times. "The new Fed Chairman [Ben Bernanke] has to raise rates once just to show the markets he's willing to do it, but then he could be done," says Hunter.
In that environment, Gorham Savings will work to protect its net interest margin ˆ which is 2.85% today, compared to 3.15% at the same time last year ˆ or boost income elsewhere if net interest income shrinks, says Hunter. One method of maintaining profits amidst tightening margins is increasing the volume of loans the bank writes or deposits it takes in. That's not easily done, though, given the competitive Maine banking landscape, especially in the greater Portland area. "You have too many banks chasing too few customers in the marketplace," says Hunter.
In response, Gorham Savings plans to use new products and marketing efforts to attract and retain business, and if necessary resort to other financial resources to protect itself from interest rate risk. For example, to fund a large volume of fixed-rate mortgages, the bank could turn to the Federal Home Loan Bank, which loans banks money at a fixed rate lower than what the banks charge borrowers. "But our first preference for funding is always from serving customers," says Hunter. "That's what we're in business for."
Peter St. John
Senior vice president, commercial services, Katahdin Trust Company, Patten
Forestry and logging-related businesses represent the largest customer base for Katahdin Trust's commercial loan division. But that business has been slowing this year, says Peter St. John, thanks to the impact of rising rates. Last year, the bank's loan portfolio grew 17%. Through November of this year, he says, that growth rate is about 8.5%.
For starters, St. John says, customers in northern Maine have been deferring plans for equipment purchases or expansion due to rising rates. And many customers with variable-rate loans ˆ the kind that would help the bank maintain its net interest margin if short-term rates continue to rise ˆ have been coming back throughout the year to convert to fixed-rate options. "It's the catch-22 for both customers and the bank to find pricing that is acceptable to both parties," he says.
St. John expects the Fed to raise short-term rates once or twice more in the coming months, but does not expect long-term rates to rise along with them in early 2006. That means an even flatter yield curve.
To protect its net interest margin, the bank is working to attract customers to shorter-term fixed rates, such as three-year commercial loans instead of five-year, or to entice them to consider variable-rate options, according to St. John. Many commercial borrowers take out 10-year loans for cash-flow purposes, even though their business plan calls for paying off the loan in a shorter time period, says St. John. For those customers, the bank is offering combination fixed- and variable-rate options that might make shorter-term loans more attractive.
Looking ahead to next year, the bank is also working to attract or maintain large borrowers through what he calls "match funding." To provide a $1 million loan with a fixed rate, for example, the bank might borrow that $1 million from the Federal Home Loan Bank, receiving a fixed rate of its own. Then, it would write a loan to the customer at a slightly higher fixed rate, giving the bank a protected margin, provided that the customer agrees to FHLB terms such as restrictions on pre-payment.
St. John, however, is not overly concerned about the bank's ability to manage its balance sheet. Instead, he is worried about the broader impact on the northern Maine economy. The combination of high interest rates, high energy costs and potential insurance premium spikes after the southern hurricanes this summer and fall has St. John concerned that his business customers might have a very tough winter ahead of them. "From our bank's standpoint, to remain healthy and have a good year, customers are the backbone," St. John says.
Greg Dufour
President and chief operating officer,Camden National Bank
Greg Dufour says Camden National began anticipating rising rates as far back as the end of 2004, and has been positioning itself to that deal with that environment.
The bank's investment portfolio was one area it looked to for protection. Around the beginning of the year, the bank began boosting its investments in 12-month to 18-month bonds, instead of three-year or four-year investments. "So as rates were rising over that 12-month period, we were having those investments mature and that money available to invest at higher rates," says Dufour.
Dufour expects the flat yield curve to remain in place through early 2006, which likely means market conditions will be similar to those in 2005. Like other banks, Camden National is seeing growing consumer demand for fixed-rate loans combined with pressure to pay more interest on customer deposits. And like other banks, Camden National is finding it hard to fight that smaller gap between what it takes in from loans and pays out on deposits. "We don't have a lot of pricing power here," he says of the Maine banking market. "Quite frankly, that's not where we try to compete."
Instead, the bank's strategy is to attract customers by touting benefits other than interest rates. Dufour says Camden National is developing a new checking account that includes features he describes as "relationship based," such as a bundle of services that include electronic statements and online bill paying. Camden National also tries to keep a local-bank feel in all its branches through strategies such as letting individual branch managers set CD rates based local competition.
If rates continue to rise in 2006, he says, the bank will continue to tweak that combination of investments, products and marketing strategies. "It's always kind of a balancing act banks go through in changing interest-rate environments," says Dufour.
Rob Johnson & Jim Delamater
Chief financial officer and chief executive officer, Northeast Bank, Lewiston
While the flat yield curve is putting pressure on all banks, Northeast says it has still managed to increase its net interest margin so far this year, boosting it to 3.43% from 3.37% in December of 2004. CFO Rob Johnson credits that increase to the bank's "asset-sensitive" position, which is banking-speak to describe a portfolio in which loans ˆ called assets ˆ reprice faster than deposits, also known as liabilities.
That position has helped Northeast take in more interest income while delaying some of the higher interest payments it will have to make to depositors given the steady rise in short-term rates this year. At the end of November, Northeast was paying 4.25% on a one-year CD, compared to the 2.65% rate it offered in the beginning of 2005.
Still, CEO Delamater says, the flat yield curve is working against Northeast as it is most banks, since customers are now largely seeking fixed-rate loans at a time when the bank wants to maintain flexibility on what it charges customers to borrow. "One of the unique challenges banks face is that customers always want the opposite of what's good for us," says Delamater.
One way to continue meeting customers' demands while protecting the bank's finances is to sell fixed-rate loans on the so-called secondary market, where institutions buy loans to package into mortgage-backed securities. The secondary market for home mortgages had been booming a couple years ago, but is now falling off, says Johnson. In its 2005 fiscal year, the bank recorded $233,000 from mortgage sales, compared to about $1 million in fiscal year 2003.
Instead, though, the bank is finding a strong secondary market for commercial loans. Buyers such as insurance companies, mutual funds and real estate investment trusts are eager to buy commercial real estate loans, which they repackage into commercial mortgage-backed securities. "In this climate, the secondary market is willing to do something banks fundamentally don't want to do," Delamater says, referring to that market's willingness to hold on to fixed-rate loans. "That creates more demand and more sales in that area."
Like everyone interviewed for this story, Delamater and Johnson expect short-term rates to continue their rise in 2006. That means the bank will continue watching its mix of loans and deposits and looking to fees from non-banking businesses, such as an insurance agency it bought in 2004, to offset any declines in interest income.
But for Delamater, the more interesting question for 2006 surrounds the fate of long-term interest rates. "What we're all watching for is if the public can get confidence in the economy and the dollar, which would drive long-term rates up," says Delamater.
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