Banks' Floating-Rate Note Bomb Will Create More Demand for Deposit Dollars and Higher Rates

Banks will have to refinance an estimated $787 billion in floating-rate notes by the end of 2009. Floating-rate notes are securities that are comprised of a variable component usually tied to something like the Federal Funds Rate or LIBOR, and a fixed component above that rate. A variable rate mortgage is a consumer version of a floating-rate note. In 2006, banks increasingly turned to floating-rate notes to fund their liquidity needs. The problem is that many of those loans are coming due and the banks are going to have to pay more to refinance them.

On the surface, it wouldn't seem like that should be a problem. After all, short term interest rates, which often make up the variable part of a floating-rate note are down significantly from 2006. But two things have happened. First, the premium, or fixed part of these loans has increased dramatically, from 0.02 percentage point above the London interbank offered rate, or Libor, a benchmark meant to reflect the rates at which banks lend to one another to at least 2 percentage points for some banks.

Still, Libor has come down by two percentage points over the last two years (12 month August ;06 Libor was 5.41% versus 12 month August 08 Libor of 3.245%) so even if the spread goes up by 2%, the borrowing cost is at the moment is nominally the same. As rates increase though, as they most likely will in 2008, that would squeeze banks as the total rate goes up beyond the 5.4% range.

The bigger problem is that the floating-rate note market has been hurt by the credit crunch and it doesn't appear that banks can raise nearly the same amount of money from it as they could in the past. The WSJ reports that:

"Even at the higher interest rates, banks are having a hard time getting cash. The securitization markets that had allowed banks to repackage loans and sell them to investors remain all but shut. Banks today rarely make loans to one another for periods of more than a week, and even some so-called "repo" loans -- in which the borrower puts up securities as collateral -- are becoming more expensive."

As a result, they'll need to turn to different kinds of higher priced debt. Or, and this is where it helps readers of BestCashCow, they will have to turn to deposits. These deposits include checking accounts, CDs, money markets, etc.

The same WSJ article states that:

"Other firms, such as Merrill Lynch in New York and Wachovia in Charlotte, N.C., have said they can tap customer deposits. Merrill, one of those worst hit by write-downs tied to mortgage-loan securities, has increasingly focused on developing its bank unit, which had $101 billion of deposits as of June 27, compared with $82 billion a year earlier.

A spokeswoman for Wachovia, which was hit by losses tied to the acquisition of California lender Golden West Financial Corp., said that 55% of the bank's balance sheet is funded by core deposits and that the bank has the ability to "seamlessly handle the refinancing of short-term debt maturities as a result of our prudent liquidity planning."

Wachovia, for instance, is offering one of the best 2-year CD rates (the same term as many of the floating-rate notes). As banks continue to turn to depositors for their funding needs, look for the competition in rates to continue.