A growing number of banking companies are following their clients' leads in aggressively paying down debt.

Still awash with deposits and seeing limited opportunity to make loans, banks are trying to lift net interest margins by shrinking long-term debt. In the past six months, the 25 biggest banks have reduced total senior debt by nearly 9%. To some observers, the maneuver is a last-ditch effort to improve short-term financial health — and could backfire should historically low interest rates eventually start rising.

"Over the long run, liabilities will price up much quicker" than assets, which could sharply pinch future margins, said D. Anthony Plath, a finance professor at the University of North Carolina at Charlotte. "By funding operations mostly with short-term deposits, we may be exposing the patient to a more serious illness over the long run."

Banks are in a difficult spot, analysts said. Improving margins now is important because any added revenue from spreads would give banks more latitude to keep purging bad loans without taking a capital hit. Though there are several tactics that can raise margins, some are unfeasible right now while others have already been used extensively.

Gerard Cassidy, an analyst at Royal Bank of Canada's RBC Capital Markets, provided a checklist of things a chief financial officer might do to optimize a collection of low-cost deposits. The first goal is to increase assets, but lending has been difficult given stagnant demand from creditworthy borrowers.

Some, such as SunTrust Banks Inc. and M&T Bank Corp., are now holding mortgages rather than selling them to Fannie Mae and Freddie Mac.

Another option involves investing in securities, but low rates on government bonds are not enticing banks to buy. On the liability side, banks spent much of this year letting high-cost brokered certificates run off. The one remaining option is paying off debt.

"Banks have relatively few choices" to improve margins, said Gary Townsend, the chief executive of Hill-Townsend Capital LLC.

"Right now everyone hates to see these reductions in the net interest margin, and senior debt is expensive if it is otherwise unnecessary."

Unfortunately, shrinking margins were the norm among big banks in the third quarter. Citigroup Inc.'s margin narrowed 8 basis points, to 3.07%. Bank of America Corp. and JPMorgan Chase & Co. both saw margins contract 5 basis points. The margin shrank 13 basis points at Wells Fargo & Co., largely because of impaired credits inherited from its 2008 purchase of Wachovia Corp.

Meanwhile, senior debt at big banking companies reached its peak in the first quarter, topping $1.58 trillion, according to regulatory filings. At the end of the third quarter, such debt came in at $1.44 trillion, an amount that is very similar to the fourth quarter of 2009. Expectations are that debt levels could edge down more this quarter.

Bank of America has shed more than $40 billion in long-term debt this year, and expectations are that the trend will continue for the foreseeable future. At Sept. 30, B of A had $478.9 billion in long-term debt, according to company filings.

Charles Noski, B of A's chief financial officer, told analysts during an Oct. 19 quarterly conference call that he expects B of A to further reduce its long-term debt by up to 20% by the end of next year. He said the Charlotte company amassed "larger than ideal" debt levels because of its acquisitions of Countrywide Financial Corp. and Merrill Lynch & Co. Removing such liabilities makes sense, because the company currently has "little control over rates and customer demand," he said.

Analysts, however, are divided over the ultimate impact such deleveraging might have, with the outcome dependent on actions by the Federal Reserve.

"In the long run, it is very healthy for the system to have less debt at the holding company level," Cassidy said.

But Plath's view is more apprehensive; he expressed concern that an overreliance on short-term funding could pressure margins should increases in deposit pricing outpace rises in rates for loans. Contributing to the problem, Plath said, are ongoing efforts to purge commercial real estate loans, which often helped margins by locking borrowers into higher fixed rates. Of course those loans, particularly ones tied to residential construction, have also played a major role in elevated credit costs.

Plath said two things could help banks avoid a train wreck with margins. First, he said it is unlikely that rising rates will become an issue this year or in 2011. Secondly, Plath said banking companies could invest in subordinated debt if the Fed delivers on expectations that it would buy longer-term bonds from financial institutions.

Cassidy said it is quite possible that banks could take out new debt at rates far below the 5% to 6% associated with the long-term debt that has been retired in the past two quarters. Townsend agreed, saying that the objective is "all about being nimble."

"That could provide banks with a chance to take on subordinated debt covering the next five to 10 years," Plath said. "The banks could have a chance to refinance debt at the lowest point in the interest rate cycle."

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