Who profits from higher interest rates?

John W. Schoen Senior Producer • Profile • E-mail

With adjustable mortgages and credit card rates rising, Henry in Maryland is wondering where the extra money on his monthly payments is going. Just who profits when interest rates rise?  In Indiana, Nick is feeling a little put out because a collection agency is still bothering him about a 7-year-old debt. Isn't there some law against this?

Who profits from the additional money I pay when the interest rate goes up? If it’s the bank or credit union, it seems that all they have to do is sit around and pray that the Fed will raise rates.
-- Henry S., Odenton, Md.

There’s certainly plenty of reason to pray for the Fed, but sitting around waiting for rate changes is not a great way for a banker to make money.

Despite the generous press coverage lavished on the Fed’s interest rate pronouncements, a lot of other, more significant forces weigh on bankers and other lenders when they try to figure out how to make money. While the Fed generally gets the most attention for the very short-term rates it controls, the central bank’s influence over the cost of borrowing is often overstated.

That’s because there are many different types of borrowing, and the rates that apply to most of them have nothing to do with the short-term IOUs handled by Mr. Bernanke and his merry bank of rate-setters. Those folks focus on just two rates: the “discount rate” charged to banks when they borrow directly from the central bank, and the “federal funds” rate that banks charge each other for very short-term (overnight) loans. (Banks borrow overnight to maintain minimum reserves required by the Fed: if one bank find it’s lent too much by the close of business on any given day, it has to borrow from another one for a few hours to replenish their reserves.)

Longer term rates — whether for mortages, Treasury bonds or “commercial paper” sold by companies raising money directly in the global capital markets — march to an entirely different drummer. Whenever you get a mortgage or a new credit card — or when a company or government sells bonds to raise money — the market votes on how much that loan is going to cost. The Fed has little direct incluence over those longer-term rates, which are determined of millions of individual decisions by borrowers and lenders that make up the supply and demand for money.

In the simplest terms, long-term interest rates are determined by how many borrowers, around the globe at any given moment, want loans and how many lenders are willing to make them. If the Fed wants to gets into this act, its best bet is try to pump money into the system or draw back out, which it does by buying or selling Treasuries. (It can also easer or tighten the reserves banks are required to maintain.)  But with long-term rates, the global credit markets almost always call the shots.

It’s that difference between long and short rates that makes the world go around for lenders. Banks traditionally make money by borrowing short-term money — from depositors (you and me), from other banks or from the Fed — and then lending it out at a higher rate to customers who borrow for the long haul. So their profit comes from the (usually) higher rates they charge borrowers compared to the bank’s lower cost of money.

That gap between short and long rates is stretching and shrinking all the time. You may have heard it referred to as the “yield curve” — which is often measured by the difference between the market rate on a 10-year Treasury bond and a 3-month T-bill. When that gap is big, the curve said to be is “steep;” when it’s small or non-existent the curve is “flat.” Occasionally, long rates fall lower than short rates; the yield curve is then said to be “inverted.” (At this point Wall Street usually freaks out because this often, but not always, means a recession is coming.)

Right now, the federal funds rate (the bank’s cost of money) is at 5.25 percent and the prime rate (one of main benchmarks for pricing a longer-term loan) is at 8.25 percent. Bankers refer to the difference between their cost of money and the rate they charge — the bank’s profit — as the “net interest margin.”  It’s not unlike the mark-up Wal-mart gets for buying running shoes wholesale from a manufacturer in China and selling them at a higher retail price to fashion-conscious high school kids who don’t care what shoes cost to make .

In fact, rising rates can hurt bank interest margins — and profits. One reason is that, as the “cost” of money goes up, a fixed-rate, long-term loan locked in when rates were lower is now less profitable. So if Fed-mandated short rates move up faster than market-driven long rates, interest margins get squeezed (which is what has happened to many banks this year.)

But there’s a flip side to the rising interest rate ledger: Most borrowers are also lenders, including you and me. Some of the extra money you pay on your credit card when rates go higher comes back to you in the form of higher returns on savings (if you keep them in an interest-bearing account like a savings account or CD.)

Here again, there are winners and losers. These days, many savers avoid relatively low passbook savings accounts in favor of money market funds that invest in longer-term loans to get a better return. As rates rise, competition for all this depositor money can also raise a bank’s costs, which can further squeeze their net interest margin.

So whether rates go higher or lower, there are winners and losers on both sides of the loan. A lot depends on the direction rates are taking — and the differences between long and short rates. And for now, the Fed seems content to leave rates where they are.

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