(By Mani) Consumer and commercial credit spreads are trending well above long term averages due to low interest rates and may hurt the net interest margin of the banks.
Banks are unable to lower funding costs below a certain level, and also facing increased capital and liquidity requirements. Meanwhile, they are also subject to increased regulatory and political scrutiny, driving up costs and risks for banks to lend.
Commercial and industrial credit spreads were 3.3 percent in the first quarter, off 15 basis points (bps) from the second quarter of 2011 peak but up 125 basis points from the 25 year average.
The 30 year mortgage spreads were 40 bps above the long term average at 2 percent versus 1.6 percent. Considering average FICO scores have increased by 30-40 points, the increase in spread is even more.
Meanwhile, credit card spreads were 170bps above the long term average at 9.1 percent compared to 7.4 percent, while auto loan spreads were 110bps above the long term average at 4.7 percent versus 3.6 percent.
As a result, banks would resort to be more aggressive on loan pricing.
"If rates remain near current levels, banks may reduce purchases of securities and instead become more aggressive in lending," Deutsche Bank analyst Matt O'Connor wrote in a note to clients.
Since mortgage rates tend to lag Treasury yields, yields on newly purchased agency Residential mortgage-backed securities (RMBS) securities, which are currently below 2 percent, may approach 1.5 percent if Treasury rates stay at current levels and mortgage rates drift down.
At current interest rates, mortgage backed securities carry much more interest rate risk than most non mortgage loans. For instance, the duration of a 3 year agency RMBS could double or triple over the next few years if mortgage rates back up 150-200bps.
"Given the uncertain macro outlook and Basel 3 impact on higher risk loans, we believe banks will opt to lower pricing on high quality loans rather than lower credit standards," O'Connor added.
The above approach would lower credit spreads for the entire industry, which are very wide versus historical levels, and pressuring bank net interest margins.