Banks’ net interest margin rises during recessions because 1) the central bank reduces their cost of funds and 2) spreads widen. That is what happened during the past two recessions, but not during the present one. NIM at US banks with assets in excess of $15 billion has fallen to the lowest level on record, as shown in this graph from the St. Louis Fed:

Net Interest Margin for US Banks WIth Assets Above $15 BIllion

Source: St. Louis Federal Reserve

Net Interest Margin stood a 4% in the middle of the last recession (second quarter 2002) but at only 2.94 at the end of 2008.

As Warren Buffett observed (as quoted in the previous post) spreads are enormous. Large banks were compelled make good on revolving loan facilities committed during the bull market years, at 2006-2007 spreads.

 A great deal of banks’ lending during 2008, perhaps the bulk of it, appears to have been involuntary. During the credit boom of 2004-2007, banks handed out lending commitments like party favors, charging customers 8 to 10 basis points per year for revolving credit facilities at fixed spreads to LIBOR. Total facilities committed stood at $2.3 trillion at the end of 2007, about three times the total volume of commercial and industrial loans. In return, banks obtained profitable fee business from customers, including underwriting and securitization. Although loan commitments are a contingent liability, accounting for such liabilities was vague at best. Only during the past two weeks have news media and Street analysts called attention to the contingent liability problem, following GM’s highly publicized drawdown of $3.5 billion from a bank facility. In the market for credit default swaps, an investor would pay 59 points up front plus 500 basis points over LIBOR per year to insure against a default by General Motors. GM can access bank credit because it previously negotiated revolving facilities.

In a Oct. 6, 2008 paper for Laffer Associates, I wrote,

To summarize,

1. Banks still have an unprecedented volume of lending commitments to corporate borrowers at spreads set during the halcyon environment of 2004-2007.
2. Bank capital remains under pressure due to past and expected write-downs of non-agency mortgage credit as well as corporate credit
3. Banks cannot liquidate assets into the present weak market environment
4. The inability of the market to roll over commercial paper of first-quality borrowers is not directly caused by a shortage of bank capital, but indirectly it reflects a market response to actual and expected shortages of bank capital.

Like hitting your head against the wall, the good news is that it feels better when you stop. It was clear from the data in mid-2008 that the banks were heading for a train wreck. But as Warren Buffett observes, once you have stabilized your capital (and gotten federal help on funding), interest margins should improve dramatically during 2009.

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