Would a Rate Hike Rock Financial Stocks? Bank on It

If the Federal Reserve Board decides to raise interest rates later this month, it could wreak particular havoc with one of the engines of Wall Street’s great bull market: financial stocks.

Few market sectors have been been hotter in the 1990s. The Standard & Poor’s index of 66 major financial stocks, which includes leading banks, insurance firms and brokerages, has rocketed almost 300% since 1990, versus a 140% rise in the blue-chip S&P; 500 index.

Much of financial stocks’ gain has come just in the last two years, as the industry has benefited from an expanding economy, stable interest rates, a turnaround in real estate values, massive industry consolidation and--most important for banks--confident consumers who have been eager to borrow.

But with Fed Chairman Alan Greenspan last week warning sternly about the central bank’s need to be vigilant about the economy’s strength and about the stock market’s heights, the chances of an official credit-tightening move at the Fed’s March 25 meeting appeared to increase sharply.

And historically, investors’ response to Fed interest rate boosts has been Pavlovian: When rates have gone up most financial stocks have gone down, often more than the market overall.

The last time the Fed was in credit-tightening mode was in 1994. Between October 1993 and December 1994, the S&P; financials index dropped 16%, while the S&P; 500 index was off less than 5%.

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Investors have tended to dump financial issues in periods of rising interest rates on the assumption that the companies’ cost of money will rise faster than the rates they can charge on loans (in the case of banks), and because higher rates choke off demand for financial services in general. In addition, rising rates threaten to push marginal borrowers into default, boosting financial companies’ credit losses and depressing earnings.

But as is often the case on Wall Street, reality failed to comply with perception in 1994: Even though the Fed doubled short-term interest rates in the course of that year, many financial companies continued to produce handsome earnings.

Banking giant Citicorp, for example, earned $6.40 a share in 1994, up 81% from $3.53 a share in 1993. Leading credit card issuer First USA’s earnings zoomed 130% in 1994 from ‘93; NationsBank’s profit rose 22% in 1994 from ’93.

James Schmidt, manager of the $4.9-billion-asset John Hancock Regional Bank stock mutual fund in Boston, said 1994 demonstrated that many financial companies today are far less at risk from rising rates than they were in the 1980s. Banks, for example, now do a much better job of matching the maturities of assets and liabilities on their balance sheets. So even as savings certificate yields rise as market rates go up, banks are rolling over a similar sum in loans and other assets at higher rates as well.

The boom in “derivative” securities in the 1990s also has allowed banks to more easily match assets and liabilities, thereby lowering the risk created by market interest rate swings.

What’s more, many banks and brokerages enjoy a higher level of recurring fee income (such as from money-management services, automated tellers, etc.) than ever before, reducing their vulnerability to a narrowing of the spread between what they pay for money and what they earn in interest.

Hence, Schmidt believes that a modest increase in rates by the Fed would have only a “small impact” on most banks’ earnings, which he now expects to rise 10% on average this year.

Even so, Schmidt concedes that bank and other financial stocks may take a sharp hit if the Fed indeed begins to tighten credit, because investors’ knee-jerk reaction would be to sell.

Michael Stead, manager of the $882-million SIFE Trust financial stock fund in Walnut Creek, Calif., agrees that a Fed rate boost would mean “initially there’ll be selling [of financial issues], but I don’t think it’ll be a disaster.” Unless the economy goes into recession, triggering a surge in bad loans, he thinks investors will continue to be lured to financial stocks by some of the market’s best profit prospects and lowest stock price-to-earnings ratios--along with the promise of more industry consolidation, with the attendant cost savings.

But some Wall Streeters worry that the heady gains in bank and other financial stocks over the last two years could lead to heavy profit taking if the Fed acts. “When people get antsy about the market, the first groups they sell are those in which they have the biggest profits,” said Philip Roth, analyst at Dean Witter Reynolds in New York.

Ed Nicoski, analyst at Piper Jaffray Inc. in Minneapolis, noted that the financial sector has been a major element of support for the bull market overall since 1994. “I think financials will be the last sector to go, and when they do it will mark a market top of some substance,” he said.

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Money in the Banks

The Standard & Poor’s financial-stock index, heavily weighted with banks, has doubled since the early 1995 and is up threefold since 1990--more than twice the gain of the blue chip S&P; 500-stock index.

Tuesday’s close: 92.4

Source: Bloomberg News