Friday, March 10, 2006

That Tricky Yield Curve

It's obvious that when short-term rates are higher than long-term rates, as is the case in the U.S., that banks are in a difficult situation. This divergence in yields is how banks rake in the dough. When the yield curve is inverted the opporutnity for yield arbitrage across time dissappears.
As rates "normalize" and the risk premium for time becomes apparent in the yields, banks should see profit margins fatten substantially. It's been a popular view of B-week that banks are doomed, and frankly, by the time a critical mass of commercial media agree on an issue, it's likely no longer true. This is my view on S&L's and will be loading up the trucks (manufactured by Caterpillar) on any signs of weakness, that is Citigroup at $45.

On the regional side, IndyMac bank is another interesting story. Essentially, they are convinced that their business model is superior because of their hybrid mortgage banking/S&L model. When rates are falling their refinancing and mortgage business does exceptionally well. In a rising rate environment, they see fatter margins on interest income. Their strategy is unique in that in rising rate environments, they seek to expand their business while most banks lay-off workers. They are actively recruiting for their Pasadena HQ.

On the rates issue, there is no question that long term yields will rise. I believe the government made a savvy move in re-issuing the 30 Year Bond last month. It's cheap financing considering the likely direction of rates.