Speculation about the Fed’s future monetary policy became more interesting over this weekend as Larry Summers dropped out from the race to become the next U.S. Federal Reserve Chairman. Summers was seen as one of the White House’s favorite candidate for the position. His withdrawal makes Federal Reserve Vice Chair Janet Yellen and former Federal Reserve Vice Chairman Donald Kohn front-runners for the top spot at the Fed. 
Both Yellen and Kohn are considered to have a dovish stance on monetary policy, and favor lower interest rates to support the economic recovery. If any one of them is chosen to replace Ben Bernanke, it could mean that the Fed will not end its quantitative program as quickly as it would have under the leadership of Summers. The markets seem to be already considering this possibility. According to Bloomberg, benchmark 10-year yields declined by nearly 10 basis points to around 2.80%, after the news broke out on Sunday. 
We believe that lower bond yields will put downward pressure on the revenue of brokerages, particularly TD Ameritrade (NYSE:AMTD), which earn a large portion of their revenue in the form of net interest income. Our price estimate for Ameritrade’s stock is just under $26, almost in line with the current market price.
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- Trading Commissions Drive Ameritrade’s Earnings As Low Yields Subdue Interest Revenues
Much like a bank, a brokerage firm can utilize its client assets (example, customer cash and deposits) to generate interest revenue. A portion of this revenue is passed on to the customers as interest while the remainder is the brokerage’s profit – its net interest income. Ameritrade primarily earns such interest income from two sources:
1) Interest On Money Market Balances: Under a special agreement, Ameritrade allows TD Bank to offer its clients FDIC-insured money market deposit accounts (IDAs). Ameritrade provides marketing, record keeping and support services for such accounts and in turn receives a fee that is based on the yield earned on the assets in such accounts after deducting the actual interest paid to clients and making some other adjustments. The company made around $828 million from this source in calendar year 2012, according to our estimates. [Note: Ameritrade’s reporting cycle ends in September and we make adjustments to its financial statements to arrive at a Jan-Dec cycle. We believe that this makes comparisons across competitors easier.]
2) Interest On Other Balances And Securities: Ameritrade offers its clients margin and securities lending services and generates interest income from this activity. The company generated around $457 million from this business in calendar year 2012.
For both of the above mentioned categories, interest income depends on the amount of interest-earning assets and the interest margin (or spread) that Ameritrade is able to generate on these assets. Unfortunately, even as the company continues to attract client assets, the interest margins on them have been steadily declining since the financial crisis. Ameritrade’s yield on money market balances declined from 3.9% in 2008 to just 1.3% in 2012, while the yield on other balances and securities dropped from 3.6% to 3.0% over the same period.
One of the major reasons for such a drastic decline in yields is the Fed’s ongoing quantitative easing (QE) program. The Fed’s response to the financial crisis aimed to boost the economy by keeping interest rates artificially low. In its third iteration, called QE3, the Fed started buying fixed income securities worth $85 billion each month to keep interest rates from rising.
With the improvement in the U.S. macroeconomic environment and the unemployment rate dropping, the Fed could look to dial back its bond purchase program. Chairman Ben Bernanke started dropping hints about the same a few months back, and bond yields have been rising in anticipation of such a move. According to a recent survey conducted by USA Today, over 60% of economists believe that the Fed will start tapering its bond purchase program after its meeting on September 18. 
However, many economists now believe that the QE roll back may not be as swift as originally anticipated. Whereas a large percentage of economists earlier believed that the Fed would reduce (taper) its monthly bond purchase by around $20 billion, new estimates for the same seem to be converging on a much lower range of $6-$10 billion.   Larry Summers’s appointment could have accelerated the taper given his reputation as a more hawkish view on monetary stimulus. With his name taken out of the hat, markets are less worried about this risk.
We believe that Ameritrade’s yield on interest earnings assets are likely to remain under pressure in the near future if there is only a symbolic reduction in the Fed’s bond purchase program in September. We currently forecast yields to remain suppressed until 2014. However, there could be a 10%-15% upside to our price estimate if yields start increasing sooner and at a much faster rate.Notes:
- Summers’ end leaves Yellen out in front, FT, September 15, 2013 [↩]
- Summers Quit Fed Quest After Democrats Spurned Obama Favorite, Bloomberg, September 16, 2013 [↩]
- Economists see Fed cut in stimulus this week, USA Today, September 15, 2013 [↩] [↩]
- Fed Seen by Economists Tapering QE at September Meeting, Bloomberg, June 21, 2013 [↩]