The long term rates such as the 10 year or 30 year yields are determined by SUPPLY of savings and the DEMAND for long term loans. Essentially this is determined by the bond market and essentially is affected by everything that goes on in the world including the growth of the world economy, the savings rates, the inflationary expectations and world politics (i.e everything).
The curve defined by the yield of similar secutites (say US Treasuries) as a function of maturity is called the yield curve. Here is a webpage which will show you the shape of the yield curve at various points of time. You can check it daily as well as get some of the most insightful bond market commentary from PIMCO .
I won't go into the gory details of the yield curve and what it means in detail. It is quite a fascinating creature actually. It not only tells you about the present supply versus demand of loanable funds of various maturities but also tells you about the future expectation of changes in itself. In short, if you want to borrow (or lend) money for 10 years, you can do it in several different ways: one fixed 10-year loan or two 5-year loans or five 2-year loans. Global arbitrage will result in making the expected cost the same. This will presume the market assumption of what the 5-year yield will be in five years from now or what the 2-year will be at various points in the future. I like the quote from financial writer and former derivatives trader Frank Partnoy, "If you don't understand the forward yield curve, you're probably losing money to someone who does". Pardon the digression.
Generally banks borrow short term funds. For example they receive checking and savings deposits or issue CDs. They also borrow from each other at the Fed funds rate and if necessary can roll over these short term loans. Similar short term loans between banks are called repurchase agreements or repos. These are loans where the borrowing bank sends some collateral to the other bank such as bonds or some financial security. Funds from checking and savings accounts are the preferable way to borrow money since the interest expected on these is minimal. CD rates and in general the short term lending rates are largely determined by the Federal reserve. The Fed directly controls the overnight lending rate, the Fed funds rate, and all other short term instruments compete with this rate and so do not differ much from the Fed funds rate.
The difference between the long end (say 10-year yield) and the short end (the 3-month yield) is called the yield curve spread or simply the spread. This number is crucially important to the profitability of banks. This is because they typically borrow short and lend long. For example they issue CDs and take these funds and offer mortgages or business loans. When this spread is large, they can make a lot more money than when the spread is small. When the spread is negative, they are actually losing money by lending. This is one reason why the spread is typically positive. There is no incentive for banks to lend at rates that are lower than their borrowing costs. So they will refrain from doing so which will reduce the supply of loans and drive up the interest rate. Like all market rates, it is all determined by supply and demand. There is also the issue of risk spreads. Riskier loans require higher interest rates over the risk-free US treasuries. When these risk spreads are higher banks make more money. When they are tight (like now), banks have to take on risk without as much compensating profitability. These periods of low risk premiums do not usually last very long and frequently end in turmoil. As Greenspan put it, "...history has not dealt kindly with the aftermath of protracted periods of low risk premiums." Often they end in too many bad loans and not enough profit on the surviving loans to make up for it. In short, there is too much money and not enough good investments to make with it.
Let's get back to our bank in question, W Holding (ticker WHI), parent holding company to Westernbank of Puerto Rico. The defining feature of Puerto Rican banks is the lack of low cost deposits. Puerto Rico is quite poor. Although part of the US, they are as about as poor as Mississippi, the poorest US state. There is not a lot of money hanging around in checking and savings accounts. Instead these banks mostly rely on brokered deposits. In essense they have to buy their funds in the money market through CDs and repos and other similar short term instruments. Although this is usualy thought of as a dissadvantage, they have other advantages that can make up for it. The main one is the low tax rates. PR banks can register as an International Banking Entity (IBE). Because PR is not a state and doesn't have full representation, they are not taxed by the US government. Remember the whole "No taxation with representation" thing?. We take that pretty serious in the US (except for Washington DC). PR banks thus have lower tax rates and can offer slightly higher rate CDs and repos because they can earn slightly higher after tax returns by investing in US treasury securities.
These IBEs are typically divisions within the bank and when the yield curve spread is positive they become incredible cash machines with very little risk involved. The only risk is that the yield curve will flatten or invert, making them unprofitable or even loss producing. However these periods are usually not long lasting. If the flattening is due to rising treasury prices (falling yields) then they have made a capital gain on those bonds which make up for the fact that yields going forward are smaller. Rising Fed funds however are simply bad for IBEs and make this business difficult. Happily, these times do not last forever. The natural state for the yield curve is to have positive slope and so the natural state of IBEs is profitability.
There can be maturity mismatch. Much of this can be handled with derivative instruments such as interest rate swaps. Generally speaking, there are short term risks but over the long term they are great businesses. They can be run with very few employees and so are extremely efficient. WHI is one of the most efficient banks in the US.
This brings us to a rather simple point. The profitability of WHI is affected by the spread. The stock price is also affected by their profitability and so one would expect a correlation between the spread and the stock price. Lets look at a chart
The red is the yield curve spread with the scale on the left. The black is the stock price (scaled arbitrarily). One can see that there is a pretty good correlation. The stock price has a bit of a lag as investors don't seem to react until reported earinngs begin to decline. You don't want to be in WHI when the spread is huge (say 2004), profitability is large and investors think this will go on forever. However buying in the 2000 recession, before the fed cut, would have made you a four-bagger in three years. You want to be contrarian. You want to get in when things are bleak and the bank is simply skating by with low profit margins. The market is short term oriented. They won't wait for things to change. However a long term investor can simply buy in here and wait. Someday, things will change. The Fed will lower rates and the yield curve will steepen. The IBEs of Puerto Rican banks will become cash machines again and the banks will grow at growth rates of 20%+. The stock price will rise and continue to rise for years as the economy recovers until the Fed decides that it is time for a slowdown. You want to get out while the gettin' is good before a new crop of investors learn their lesson about the yield curve the hard way.
