Finance industry: on cusp of change - The Economy

IT WAS 1993 AND there was an interest rate free-fall, strengthening the bank and corporate balance sheets ...

We may look back on this current financial condition as an historic moment, where people were happy, puzzled and maybe a little bit cautious depending on their point of view.

Investors, consumers and financial wizards may look back with a shine in their eyes to a moment when interest rates bottomed out and became stable.

Or, if the economy doesn't show any signs of growth by January, they may look back with bloodshot eyes instead.

Even as the historically low interest rates have consumers smiling (except the ones who are still investing in CDs), the economic implications of the current interest rate free-fall, as some call it, are vast and difficult to forecast.

Exactly what the situation means for our future investment and borrowing power involves more speculation than projection.

With inflation under control and the rates so low, the financial markets are at an interesting place. Many can't see any reason why the rates should go up anytime soon even though some members of the Federal Reserve Board have warned that it's possible.

"We have to separate wishful thinking for what we think will happen," Ed Robertson of Robertson and Associates says. Robertson is a financing consultant who deals exclusively in the commercial market, and he says banks are feeling a little bit more confident these days.

Interest Rates

Period averages, as of 9/7/93
Percent

              1992 Q4    1993 Q4E

30-year government bonds
              7.5        5.9

3-month T-bill rate (discount basis)
              3.1        3.0

Federal funds rate
              3.0        3.0

Prime rate
              6.0        6.0

Annual Interest Rates

                   1991     1992     1993E     1994E

30-year government bonds
                   8.1      7.7      6.6       5.5

3-month T-bill rate (discount basis)
                   5.4      4.8      3.0       2.8

Federal funds rate
                   5.7      5.1      3.0       2.8

Prime rate
                   8.5      7.8      6.0       5.8

Sources: Federal Reserve Board of Governors, Paine Webber
Economics Group

In his market niche, where he deals with insurance companies and banks, rates are still in the 9 to 9.75 percent range.

But for the average consumer, the rates are much lower and floating around 6 percent or below.

"The banks are getting a very good margin because rates are so low," he says. "They're fixing rates up to five-year periods, which was absolutely unheard of four or five years ago."

Mortgage rates are below 7 percent for the first time in 20 years, and for those who didn't purchase overpriced homes in the 1980s, it's a refinancing dream come true.

"In the last year, banks started fixing rates for a year-at-a-time, then they said, okay, we'll stretch out to three years, and now some are willing to fix for five years."

Besides speculating about what the outcome of these conditions could be, the fixing in itself is an indication that lenders expect the rates to stay the way they are, at least for a while.

"When I was younger, I was so smart because I'd read all this stuff and figured it out. I don't know if it's maturity or just being lazy, but now I have no idea," Robertson says.

"The older I get the dumber I get and I don't try to anticipate anymore," he says. "I just try and get myself into a position where I can react."

And nearly everyone seems to be doing his share of reacting, including the banks.

Banks are at a crucial spot, where nationally they have seen record profits while at the same time consumers are taking their money elsewhere to government bonds and mutual funds, where the returns on their investments are higher.

Banks are getting into the business of mutual funds and alternative investment plans. Banks also have to prepare for a negative spinoff from the low rates.

Banks do a good business loaning money at low rates, then later on when rates jump, their profit margins shrink as they pay more on CDs and other markets.

Banks are saying what goes around comes around, especially true for the financial markets.

"We're looking at our concern that rates go lower on the long range," says Mike Stanford, president and chief executive officer at First State Bank in Albuquerque.

But Stanford says with inflation nipped in the bud and the economy on a slow path, he can't see the Federal Reserve Board lowering interest rates any further.

"If the rates go longer in the long term, if that happens to banks and stays that way for three or four years, there'll be a squeeze on margins," he says. "We're really paying attention to that to make sure our costs are in line. I think they can go lower on the pricing side of lending."

Stanford says deposits are growing at his bank and that they're seeing most of sales coming from outside of a bank in their mutual and other fund sales network. Banks are getting into the mutual fund business these days as a matter of necessity.

"As a bank, you have to play it both ways and position yourself," Stanford says.

Nearly everyone agrees that the more the government stays out of the business, the better off the business will be. However, in reaction to the savings and loan crisis, Congress tightened up lending rules, making it more difficult for small businesses to capture loans at the low rates.

President Clinton has voiced support of loosening the rules a little to give the lenders a better edge and less paperwork, but so far that hasn't happened and banks are still cautious about lending the small business loan.

And because the Fed has been reluctant to lower short term interest rates, banks may not cut their prime rates until next year, some investors say.

The prime rate is often used to set interest rates for consumer loans. Although some smaller banks have cut their prime rates, the bigger banks have not followed.

While the bottom line numbers show an accurate picture, the psychological condition of consumers and investors plays an equally important role in how things turn out in the end. Understanding that condition requires looking backwards.

Interest rates are directly tied to inflation and economic growth, which is measured through gross domestic product.

Historically, interest rates have been below 6 percent looking at 10- to 30-year bonds, which are key for judging interest rates.

With inflation in the 1980s, interest rates were so high people were getting 14 to 15 percent on CDs, but they weren't really making money when inflation was taken into account.

"You are still losing money; you are not getting ahead," explains Jeff Weston, investment representative with Edward D. Jones & Co. "That was a time in our economy when things were in great turmoil, resulting in high interest rates (and high inflation)."

During the Reagan years -- politics aside -- money management and tax policies encouraged rapid economic growth. The policies allowed a growing economy and at the same time kept control of inflation. As inflation fell, the number of jobs increased and interest rates began falling. For a time, the outlook was good.

"But what changed was the deficit caught up with us," says Weston. "As the economy is a cyclical beast, we hit that cycle at about the same time we saw a growing unemployment, suddenly a slowdown in the economy, the recession, and suddenly somebody slammed on the brakes.

"When there's economic recession, there is no pressure on interest rates because there is no inflation."

By some opinions, the Feds lowering the rates revealed a still sluggish economy. They were able to push them down because of the recession and the strong demand. So with economic conditions as they are now with slow, moderate growth ahead, it looks as though there will be a stable interest rate for the next few years.

"Now we have very close to about a 2 percent inflation rate and we're looking at projecting for the remainder of '93 and some of '94 a growth in the gross domestic product of about 3 percent," Weston says. "We're expecting a moderate but steady growth rate of 3 percent with an inflation rate of close to 2 percent."

Unless there is a sudden upward turn in the economy, inflation will likely remain relatively stable and rates should stay the same.

"On short term money markets and CDs, interest rates are bottomed and arguably they can't get any lower," Weston says. "If there's no inflation and a slow, steady economy, there is no way the banks can go out and earn enough money buying anything different than they do now.

"The banks' spread is not going to change enough to cause a short term change in rates.

Banks and insurance companies are the largest buyers of bonds. They are buying bonds and paying about 2.5 percent.

"Unless they loan at 10 percent, most banks are just loading up on bonds so they have a guaranteed spread of profit," Weston says. "If interest rates stay down, it's not great for the bank.

"They're not making a good return on their investments, plus people are taking money out of banks and putting money into bonds and the stock market," he says. "We've never been happier because in our business, we are the beneficiaries. People who would never have considered buying a bond or utility stock are now doing it."

So banks are restructuring their business tactics in response.

"If you take a bank that has a four-year average life to its investment portfolio and rates go down further, they will lose the advantage they've had most recently of having a high rate portfolio," Stanford says. "If this continues another four years, the assets will be priced down, putting a squeeze on the bank."

Senior citizens are especially hard hit with interest rates so low. In effect, they have taken a pay cut and are being forced into other, more profitable avenues of investment.

"The rate situation is both good and bad. The retired couple living on the income from their investments are being forced to make a change," says Weston. "They are buying, for the most part, Ginny Mae and Fanny Mae government bonds."

What many believe the economy now needs is an easing of the lending requirements so small businesses can get the loans and maybe the return of the benefits to real estate investments through credits and incentives.

Banks are in the business of real estate investment, and that would put them in a better position for lending.

Despite the lack of real estate incentives, the market in Albuquerque is picking up.

"I've been in the lending business for 20 years and I've seen four monstrous shifts in the market interest rates to 20 percent," Robertson says. "The other was the 1986 change in tax laws, which overnight took 20 percent off income producing property.

"When that happened and I started seeing the effects, I thought it would be 50 years before the market adjusted to this shock."

Investors bought up apartment complexes in 1986 and ran with high profits out of accelerated depreciation. The change in tax laws plus a glut of commercial property wiped out the value.

"Now I'm watching rents go up like crazy to make up that deficit," Robertson says. "I thought it would take 10 to 15 years to cure all that. I end up focusing on the New Mexico and Albuquerque economy and with the lower rates here.

Economic forecast

Seasonally adjusted at annual rates, except where noted, as of
9/7/93
Percent

                              1992 Q4      1993 Q4E

Nominal GDP                       9.2           3.9
GDP Deflator                      3.3           1.9
REAL GDP (1987 $)                 5.7           2.0
Real domestic
purchases                         5.4           2.3
Final sales                       5.8           2.0
Consumer spending                 5.6           2.5
Gross private
domestic investment              13.3           4.5
Fixed investment                 14.0           4.5
Business fixed
investment                        7.6           4.4
Equipment                        11.5           5.0
Structures                       -2.1           2.5
Residential
investment                       32.8           5.0
Government
spending                         -1.4          -0.2
Federal government               -3.5          -2.2
State & local
government                        0.0           1.0
Net exports
(billions)                     -$38.8        -$79.0
Change in
inventories (billions)           $8.7          $6.4
Change in nonfarm
(billions)                       $7.5         $10.0

Sources: U.S. Department of Commerce, Bureau of Labor
Statistics, Federal Reserve Board of Governors, Paine Webber
Economics Group.

"Five years ago, a lot of people were living with mom and dad. They're coming out and everybody is upgrading, apartments are full, and now for the first time in five years, you see apartment plans."

Meanwhile, the financial players await the effects of President Clinton's economic plan for further effects on the market and rates.

If the plan turns into a redistribution of the wealth rather than a spreading, that could mean higher rates in the future.

PaineWebber says . . .

President Clinton's narrowly-based tax hikes are resulting in a broad-based negative public reaction, according to PaineWebber's Monthly Economic Review in September.

It means a lower consumer confidence with interest rates having to work harder than otherwise to offset a feared negative cash flow and the "disincentive impact" of higher taxes in 1994, say the analysts.

PaineWebber says the current economic climate may also result in an overreaction by the public to the North American Free Trade Agreement as well as on universal health care.

E. David Grenham is a freelance writer in Belen and Socorro.

COPYRIGHT 1993 The New Mexico Business Journal
COPYRIGHT 2004 Gale Group