Wealth management’s multimillion-dollar interest rate problem
The Federal Reserve’s efforts this year to boost the economy are costing some wealth managers hundreds of millions of dollars.
The reason stems from the Fed’s decision to bottom out interest rates earlier this year. That move helped keep markets intact and the economy afloat amid a global pandemic, but it also dealt a blow to financial institutions with revenue tied to these rates. And the timing couldn’t have been worse for some firms that have recently become more reliant on interest income.
Relief on interest rates may not be around the corner. With another coronavirus wave washing over the U.S. and the globe with renewed force, the Fed has signaled that federal fund rates aren’t going up any time soon.
“Low interest rates are going to hurt all kinds of financial companies,” says Patrick Leary, chief market strategist at Incapital, an underwriter and distribution company.
Combined with other hurdles presented by the coronavirus, from shuttered offices to canceled client events, it’s been a challenging year for wealth managers. While some pandemic-related problems can be addressed via technology (think Zoom replacing face-to-face client meetings), the interest rate environment has still taken a toll on revenue. Indeed, third-quarter earnings — from banks, wirehouses, regional and independent broker-dealers and discount brokerages — underlined the industry’s sensitivity to the Fed’s call.
“We are eyes wide open on what's going on in the interest rates in this world,” Morgan Stanley CEO James Gorman said on an earnings call Oct. 15. Morgan Stanley’s net interest revenue fell by $154 million to $889 million in the three months ended Sept. 30. E-Trade Financial, which Morgan Stanley acquired in October, was also impacted, according to Gorman.
E-Trade, Charles Schwab and other discount brokerages were particularly vulnerable to the interest-rate slash as many of them had cut their commission fees for clients at the end of last year.
“It took out another revenue stream,” says Pete Crane, whose company, Crane Data, analyzes and publishes money market fund and cash management data. “And of course it took it out at exactly the wrong time.”
The blow to wealth managers’ earnings arrived on the heels of five years of healthy federal fund rates. Money market fund yields topped 2.0% at the end of 2019. Some broker-dealers became more reliant on the net interest they could make off client cash, as they eliminated money market fund sweep programs and pulled client cash into affiliated or third-party banks.
But with an economic crisis in tow, the Fed slashed the federal fund interest rate in March to 0-0.25% in an effort to boost the economy. It was the first time rates have been so low in five years.
A mighty headwind
In a press conference earlier this month, Federal Reserve Chairman Jerome Powell said the central bank would maintain its federal funds rate until labor market conditions improved and inflation had risen above 2% and was on track to remain so. In September, Fed officials said they expect interest rates to stay near zero until at least 2023.
Meanwhile, the effects of low rates are showing up on earnings statements.
At Charles Schwab, where net interest made up 55% of its overall revenue in the last quarter, revenue from interest-earning assets decreased by $288 million to $1.3 billion. On the company’s earnings call in late October, Schwab CFO Peter Crawford referred to the interest rate environment as “a very formidable headwind.”
At Raymond James, interest income fell by $119 million from the year-ago period. Ameriprise said revenues and earnings were reduced by $116 million year-over-year due to short-term rates.
Recent history suggests that low-interest rates, once slashed, can stay that way for a long while. Prior to March, the last major reduction in short-term interest rates, aimed at enticing consumers to purchase homes, borrow money and keep spending, took place in December 2008. The Fed didn’t raise rates for seven years.
“Looking at examples and the big picture — it doesn't make you feel good,” says Crane.
For broker-dealers, higher interest rates can be lucrative. When clients leave cash in their accounts, banks and brokerages may invest or loan out that money for a profit. Companies make money off of the difference of that revenue and what they pay clients in interest.
Bank of America, which owns Merrill Lynch, pays the broker-dealer up to $100 per year for each account that sweeps cash into its bank deposit program, according to a Merrill Lynch disclosure.
“The deposits provide a stable source of funding,” according to the disclosure, which states that Bank of America uses it to help fund business activities.
In June 2019, LPL Financial said it had garnered $173.1 million in quarterly gross profit from cash sweeps — nearly a third of its total gross profit for that period.
When margins tighten for brokerages, cash yields shrink for clients, too.
Broker-dealers from Fidelity to Merrill Lynch are offering clients a meager 0.01% on their uninvested cash. Money market fund yields aren’t looking any more enticing. In recent months, asset managers have offered fee waivers to keep returns from going below zero.
The rates have just been abysmal in a lot of places.
“The rates have just been abysmal in a lot of places,” says Frank Bonanno, managing director of StoneCastle Cash Management, which offers RIAs a FDIC-insured high-yield option for their clients’ cash.
Even so, clients, at least for now, are keeping record levels of funds in cash. And long-term treasury yield rates have risen in recent weeks — the 10-year rate reached 0.91% on Nov. 16 — good news for broker-dealers, according to Crane.
“Even if rates overall are glued to zero, as long as there's a yield curve, as long as there's a little difference between short and a little bit longer rates, [brokerages] can make money,” he says.
And while interest rates may be compressing revenues, there are other concerns taking precedence. Coronavirus cases are surging in the U.S., prompting authorities to consider new measures that may lock down large parts of the U.S. economy for the second time this year.
“The traditional metrics of profitability and doing business have gone out the window,” Crane says. “It's just raw survival for entities saying — you know, we'll figure it out after we make it through.”