Higher federal interest rates have reshaped banking, spurring a war for deposits, concerns about mortgages and a balancing act to keep up bank profits.
All the while, bank executives are watching the economy, handicapping the odds of a recession, and watching to see which way interest rates will go next.
The Business Journal contacted several banking executives to gauge their outlook on rising rates, a housing correction and the direction of OC’s economy. Following are their edited responses.
How are rising interest rates impacting your bank?
Ivo A. Tjan, Chairman, chief executive
CommerceWest Bank
Irvine
Rising interest rates in general have squeezed the net interest margins, which results in reduced operating profits. Banks now are more hands-on in pricing and structuring loans and deposits. However, there are some banks out there that are being too aggressive on pricing on the depository side, which could cause issues later on. Banks with primarily fixed rates on their balance sheet will continue to experience a lower net interest margin in a rising rate environment.
Gene McCo, Chief executive, president,
Tustin Community Bank
Tustin
Rising rates combined with increasing competition and slower loan demand has created a squeezing in most banks’ net interest margin. While the recent pauses from the Fed have slowed prime rate increases, they haven’t caused savings and Treasury and CD rates to drop. Consumers are shifting money from low-rate savings accounts to higher-yield accounts, further intensifying competition. On the positive side, banks continue to make adjustments for the flat yield curve. I believe deposit costs should stay flat for the few months. With the local job employment still strong, credit quality should remain high in the near term. This will help minimize bank loan losses and contribute to profitability. Banks have been profiting from increased fee income related to deposits and loans.
Robert B. Hiltdt, Chief executive, president
MetroPacific Bank
Historically, rising interest rates have been associated with slower growth of bank loans and deposits. When the Federal Reserve raises the Federal Funds rate, it reduces the supply of reserves in the banking system. Certain deposit liabilities of banks are subject to reserve requirements. Therefore a higher Federal Funds rate and a smaller supply of reserves can slow down growth in deposits. If, however, banks can substitute other forms of funding for deposits they may be able to fund loan growth at the same rate as before, only with tighter margins. In addition, rising rates tend to cause borrowers to delay financing decisions.
Ash Patel, President, chief operating officer
Premier Commercial Bank
Anaheim
Rising rates impact both sides of a bank’s balance sheet. If a bank has its loans re-pricing faster than its deposits, then rising rates help the institution from a profitability standpoint. The reverse is true if the liabilities re-price faster than the assets.
While many banks have assets re-pricing faster than liabilities, most are seeing their interest income shrink due to the shape of the yield curve. Lending rates have not increased at the same rate as deposit rates in many areas of the country.
Raymond Dellerba, Chief executive
Pacific Mercantile Bank
Costa Mesa
Rising interest rates affect everyone when they are driven from the Federal Reserve level. The banks must increase their prime borrowing rate and that is usually a nationwide effort.
Walter Hannen, Chief executive, chief operating officer
First Vietnamese American Bank
Westminster
While interest rates rose earlier, they still are at relatively low levels. That means most individuals and businesses will be able to adjust and continue in a relative strong financial position. The stock market reflects this in its present highs. The challenges facing us are less interest-rate driven and more the dramatic increase in our national debt, imbalance of trade and pending transition of the baby boomer generation into retirement. Still, Orange County is in a much different condition than in the early 1990s when real estate lost value of up to 30% or more. No single industry like aerospace is a prime driver, there is much more diversity now. The local economy and job growth are more robust and there is not an overabundance of residential inventory like the early 1990s. In addition, people are still arriving here and that drives the economy in a positive way even if that crowds our freeways and life.
Are foreclosures/late notices for homeowners on the rise?
Tjan of CommerceWest Bank
We do not deal with mortgage loans. However the local and national statistics all point to increased delinquency and foreclosures. The real estate market in Orange County and the surrounding area has had an unprecedented run-up in the past four to five years, and we believe what goes up that fast must go down or flatten in the next two to three years. People are also more leveraged these days than in the past.
Micco of Tustin Community Bank
We don’t make home mortgages. However, many institutions already have seen a rise in mortgage delinquencies, from lower income households, which could turn into an increase in foreclosures.
The proliferation of no down payments coupled with very low teaser rates triggered housing opportunities for many, who previously had difficulties qualifying. Variable rates move quickly to market change increases and most lower income borrowers can’t afford the increased payments. This will fuel higher delinquencies and foreclosures.
Hildt of MetroPacific Bank
MetroPacific Bank does not keep a portfolio of residential loans. All of our residential mortgages are pre-sold into the secondary market.
Patel of Premier Commercial Bank
As we don’t deal with residential mortgages, we haven’t seen a rise in foreclosures/late notices.
Dellerba of Pacific Mercantile Bank
According to DataQuick, foreclosures are on the rise but not yet at an alarming level. However, they have more than doubled from last year.
Hannen of First Vietnamese American Bank
We see mortgage foreclosures rising in many communities, mostly the result of zero down and negatively amortizing mortgage programs where people have minimal investment to buy a home. Our local community has been the opposite. We traditionally make significant investment in our homes and plan far ahead to ensure the roof overhead is never threatened. One’s home is sacred. We do not foresee foreclosures being a threat or problem here. In fact, many here have taken out additional lines of credit hoping there will be bargains to buy up.
Do you see signs of a national recession as some economists have suggested? What’s the impact of the federal deficit, inflation? Do you see a lending slowdown?
Tjan of CommerceWest
We have for the past 12 to 14 months predicted an economic slowdown or recession in 2007. All the economic data we study supports this theory. The economy is cooling, housing prices are softening, mortgage loan origination is down considerably and consumer confidence is down. We do see a continued slowdown in consumer lending, mortgage lending, and construction lending. Commercial loan demand will continue to be somewhat strong for the next nine to 18 months. However we are cautiously watching the local economy for signs of weakness in small to midsize businesses.
Micco of Tustin Community
Many factors indicate a slowing national economy, but consumer spending still remains fairly strong and that stimulates business. An economist I worked with several years ago equated it this way, “If the nation has the flu, California might catch a cold, and Orange County would have the sniffles.” Regarding the deficit, defense spending and the rebuilding efforts following Katrina will still impact the federal budget. However, the high fuel costs have begun to fall and corporate profits appear strong. I would expect inflation to drop slightly and the monetary policy to remain tight. In our end of the business, I don’t anticipate a change. Cash-rich, larger corporations won’t have much credit needs, while smaller firms will continue to borrow, investing in technology upgrades and capacity to expand.
Hildt of MetroPacific
The last national recession ended five years ago. Most economists are divided as to whether or not this economy will slip into a recession. A key to the support of the national economy is if the Federal Reserve is able to keep interest rates low. The nation has evolved from a manufacturing-oriented economy to a service-oriented economy in the past several years. The manufacturing sector is more subject to volatility than the service sector. Based upon recent reports by the federal government, the economy has slowed, which tends to reduce inflation. A key economic indicator to watch is consumer spending. If consumer spending (65% of all U.S. economic activity) wanes, it could very well bode for a lending slowdown.
Patel of Premier Commercial
I do see an economic slowdown for 2007 and 2008. Housing has been driving the economy for the past couple of years. As interest rates rise in the mortgage sector, we have seen a slowdown in the homes purchased (both new construction and existing). A slowdown will impact not only jobs but the property values of homes. That in turn impacts the amount of money people can borrow to pump back into the economy.
I don’t feel as though there is significant impact by the deficit. The Federal Reserve has targeted inflation and is working to keep it under control. However, the longer the interest rates are kept artificially high, the deeper the slowdown will be. Certainly, as the economy slows, lending demand will slow.
Dellerba of Pacific Mercantile
There seems to be an extraordinary situation with the severity of the inverse curve. As a rule of thumb, when the spread between the 90-day Treasury and the 10-year bond goes negative, the chance of a recession increases as the spread widens. (The 90-day Treasury is at 4.95%, and the 10-year Treasury bond is at 4.71%, with the difference being a negative 0.24, which probably indicates a 30% plus chance for a recession). There is more involved here than just this formula, but we should be aware of it. The federal deficit competes for money just like we do and this causes the cost of money to rise. Inflation robs everyone of future buying capacity. Real estate lending is certainly slowing down as the rates go up.
Hannen of First Vietnamese American
A national recession is almost an attitude. If we believe it, then it will come. We do need to demand that all levels of government treat our money like we must do with our own household budgets,spend what we can afford and spend it for things that create value. Lending slows down every time there is an increase in the interest rates due to a measurable percentage of people and businesses not then being willing or able to borrow. Recently, for many, their savings accounts have been the increasing equity held in real estate. Given the doubling over the past few years, any decrease in value is not a major event. Overall equity,and the ability to borrow against that equity at historically low rates,remains huge.
What’s your bank’s strategy now that rates are stuck at 5.25%, with prospects they might even fall in 2007?
The bank will continue to aggressively market our remote deposit solution product, which allows clients to deposit checks in their offices remotely. It will allow us to drive core demand deposits and not get into the CD wars we are seeing with a lot of financial institutions. We have been managing our loan and investment portfolio against a down rate scenario in 2007 for the last 12 months. It is as important for banks to focus on a future down rate environment, as much as it is in a rising rate environment.
We have kept the term of our funding costs short and have placed interest rate floors on our floating rate loans. We have two primary niche business lines (indirect lease and indirect auto), which offer fixed rate loans well above industry averages. Our second-quarter net interest margin was in the mid 8% range, and we anticipate that it will remain strong for the rest of 2006.
The Federal Reserve raises rates to control inflationary pressures. Rates steadily have increased from June 2004 (1.25%) to the current rate (5.25%) in June. The Federal Funds rate has remained static since that last move in June. In fact, many economists predict rates have reached their zenith and will be flat to down over 2007. In a rising rate environment banks tend to enjoy a spread advantage as many loans are tied to an index that floats with increases and decreases in the federal funds rate (an example is the prime rate). Rising rates typically drive customers to CDs with banks then forced to closely manage the margin. Our bank’s strategy is to work hard at traditional relationship banking by developing products, services and be responsive to our customer’s needs.
Various interest rate scenarios require banks to position their balance sheets in a manner to take advantage of interest rates. We feel as though rates will decline in the future and are taking appropriate steps to position the bank’s balance sheet to take advantage of these rate fluctuations.
We are a small business lender and we have not seen a slowdown yet. The economy still is positive to date. A gross domestic product growth rate of 1.6% seems anemic to me and close to stopping altogether. We do not make very many SBA loans because that field of lending already is overloaded with lenders and the major banks do the majority of those loans to pass their Community Reinvestment Act requirements.
We seek to improve our abilities and find new ways to serve our community. Those include a broader range of financial services and being better able to respond to our customers quickly and efficiently. That means we are constantly seeking ways to evolve internally to become a better bank. That said, we have creatively structured our loans to allow for benefit to both the customer and the bank regardless of a rise or fall in interest rates. After all, the bank must structure credits so they enhance a borrower’s ability to pay back the loan and the bank also must be willing to work with every customer during changes in the economic environment.
What trends do you see in terms of small business lending? Is there a slowdown? Are things picking up? Are SBA-guarantees working, or are they on the rise?
Tjan of CommerceWest
We still see a strong demand in terms of small business lending. SBA is a great tool for many businesses that are looking for more flexible lending. We believe that the local businesses will continue to flourish for the near future. The challenges for business will occur somewhere in mid- to late-2007 and 2008 and possibly 2009. The interest rate environment, the general cool down of the economy and the elections may cause a slowdown in some of the businesses in Orange County.
Micco of Tustin Community
There has been some slowing in loan demand, caused by rate uncertainty and the slowdown of construction. The local economy is still strong and new business startups are plentiful. Approximately one-third of SBA 7a loans are provided to new businesses. For those businesses meeting SBA requirements, this can be one of the best financing sources.
Hildt of MetroPacific
Growth in the economy coupled with increased competition within the banking industry has resulted in an increase in loans to small businesses. Businesses are expanding and financing inventory and equipment. Most banks have been actively involved in financing commercial real estate. Regulators are seemingly becoming more nervous about banks financing commercial real estate. We will, therefore, begin to see a fairly significant shift back to the more traditional business lines of credit, equipment, inventory and SBA loans. In fact, our SBA division is receiving more referrals than ever before. We are optimistic for small business loan prospects in 2007.
Patel of Premier Commercial
During times of economic boom, small businesses are conceived and plans put into motion. Many of these plans will continue though the economy has softened. This lending will continue for the foreseeable future.
Hannen of First Vietnamese American
The bank is seeing a broad range of loan opportunities, more than ever before. We have added staff to better process each loan application. SBA guarantees are certainly one way to fund certain types of credits and we have seen an increase in potential SBA funding for certain franchise businesses.
