Beleaguered financial institutions looking to shore up their funding are battling for your deposit dollars, driving interest rates on bank products abnormally high. At first glance, that's fantastic news for consumers who are finding CDs that yield 4% and money-market accounts that pay 3%. But the competition for money — which will surely intensify as new bank holding companies like Morgan Stanley, Goldman Sachs and American Express amp up efforts to attract deposits — is also squeezing banks' profit margins, further straining an already weak industry and stressing smaller banks, many of which didn't go hog wild making risky loans in the first place. "Higher rates are a short-term fix," says Camden Fine, president and CEO of the Independent Community Bankers of America. "Eventually, you feel the aftereffects."
Consider that the average yield on a one-year CD is 2.39%, the same as it was in mid-August, according to a weekly survey by Bankrate.com, even though the prime rate — the rate at which banks lend to their most creditworthy customers — has fallen from 5% to 4%. That means a bank that used to borrow at about 2.5% and lend at 5% now borrows at 2.5% and lends at 4% — an entire percentage point has been stripped from the bank's ability to make money. More than half of all banks saw their net interest margin — a measure of profit — fall in the third quarter compared with a year ago, according to the Federal Deposit Insurance Corporation. "After you pay your stockholders and employees, maintain your capital ratio and fund your growth, it gets pretty tight," says Mike Menzies, president and CEO of Easton Bank & Trust in Easton, Md. (See pictures of the recession of 1958.)
Taking the lead in pricing up the market are the institutions most battered by the credit crisis and flagging economy. Among the companies offering the highest yields on CDs are GMAC, the financing arm of the carmaker GM; Corus, a Chicago bank that has lost substantial money on construction loans; Wachovia, the Charlotte, N.C., bank whose sale to Wells Fargo was brokered by regulators in October; and the bank affiliate of the insurance company AIG, which the Federal Government started bailing out in September.
Yet even banks on more solid financial footing and those that sell themselves on qualities other than high rates are finding they have to keep up. "People who bank with us aren't going to bank with us because we're the highest rate on the street, but if we're too much under the market, at some point they'll leave," says Steve Andrews, president and CEO of the Bank of Alameda. The San Francisco Bay Area bank has been forced to keep rates artificially high, Andrews says, as one flailing competitor after another — IndyMac, Washington Mutual, Downey Savings & Loan — has pushed up rates in an attempt to attract deposits and stave off insolvency. "It's frustrating riding into work and hearing about [deposit rates] at 4%," says Andrews. "That's prime rate — there is no margin."
And more competition is on the horizon. In the past two months, Goldman Sachs, Morgan Stanley, Raymond James, GMAC, American Express and business financier CIT have all applied to convert into bank holding companies, partly in order to be able to get access to cheap funding through deposits. GE Capital, the finance arm of GE, is planning on doubling its deposit base, which it garners through broker-sold CDs, to $81 billion next year. Goldman Sachs is on track to open an online bank. Morgan Stanley, which already has $36 billion in deposits, is selling billions of dollars' worth of new CDs and looking at other banks it might buy. "It's really changing the landscape," says Timothy Koch, a professor of banking and finance at the University of South Carolina's Moore School of Business. "My recommendation to bankers is get all the capital you can, get all the liquidity you can, and lock in customers now, because they're going to have a lot of alternatives."
(Read "Treasury's Plan for Mortgage Rates Could Be Costly.")