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Higher interest rates: A bitter pill for banks

FORTUNE — Higher interest rates may not translate into fatter profits for the big banks — at least not just yet.

Banks have been bemoaning the low interest rate environment for years as it has translated into scant profits from lending and writing mortgages. But with the Federal Reserve signaling that it might finally be ready to hike rates, there is concern that the banks may be in for a rude awakening.

That’s because the prolonged low interest rate environment seems to have made the public extremely sensitive to rate hikes. If this sensitivity continues, it could translate into a steep drop in overall loan demand, which, in turn, would wipe out any incremental gain the banks earn from fatter spreads — possibly, even more. The only way to assuage the public’s concern in a rising rate environment is to convince them that the economy is booming — which seems like a tall order.

Reading over one of the big banks’ quarterly earnings reports can be mind-numbingly painful. That’s because the banks have over the years become complicated labyrinths of disparate business activities — ranging from broker dealing to mortgage lending. But new rules are set to come into force that will eventually bar depository banks from engaging in activities that stray from what is essentially the “traditional” bank model, which is to simply make loans and take deposits. Lending hasn’t been the biggest moneymaker for the big banks in decades. Indeed, banks branched out to find ways to boost profits for that reason. It worked well, until it didn’t — i.e. the financial crisis.

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But if the government wants the banks to return to the traditional deposit-and-lend model, they sure haven’t made it look enticing. That’s because the Federal Reserve, through a series of convoluted actions, has managed to keep core interest rates super-low for a long time in a bid to stimulate the economy. As a result, the banks’ net interest income — which is the difference, or spread, between what a bank earns on making loans and what it pays depositors — collapsed, making it hard for banks to make money the traditional way.

By the first quarter of this year, things had gone from bad to worse for the banks on this issue. The net interest margin, which is net interest income as a percentage of a bank’s total risk-weighted assets, at the large depository banks (Citibank (C), Bank of America (BAC), JPMorgan (JPM), and Wells Fargo (WFC)) fell, somewhat significantly, compared to where they were in fiscal 2012, according to analysis by SNL Financial.

By lowering rates, the Fed hoped that loan demand would grow and that the banks would lend more as a result. But the risks associated with lending to borrowers with less-than-stellar credit seemed too much for the banks to deal with. After all, this is how they got in trouble in the first place. The government thought they were countering that risk by forcing the banks to hold more capital on their books. But in doing so, the banks had less money to lend out.

In May, the banks got their wish — the Fed indicated that it would allow rates to float up by the end of the year. Share prices of the big depository banks took off like a rocket in anticipation that the higher rates would lead to an increase in profit.

But bank share prices weren’t the only things that jumped up on the Fed news; so did yields on 10-year Treasury bonds: from 2.19%, before the Fed announcement, to 2.57% as of July 11. This has pushed mortgage rates up from a near-historic low of around 3.35% at the beginning of May to around 4.45% at the end of June. At the same time, commercial loan rates also jumped on average for nearly all borrowers.

The bump in mortgage rates and commercial loan rates means that the banks will probably see a bump in profit as their net interest margins expand. But the flip side is that they could also see a decrease in loan demand. Whether they make or lose any money is based on which comes out ahead.

Now, rates are still so low that one would think that loan demand wouldn’t taper off too much. But that assumes two key things: 1) that people think that the economy will grow over the medium- to long-term and 2) that the housing market is booming. If the economy is growing, people will want to invest more and so they will be willing to pay the higher interest to borrow from banks. At the same time, if the housing market is booming then people will be more apt to pay higher interest rates to snag that dream house.

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But things don’t look so good for the banks, at least at this point. It turns out that 80% of the banks’ mortgage lending activity last year focused on people refinancing their existing mortgages as opposed to creating new mortgage loans. Refinancings obviously don’t do well in a rising rate environment, so some decrease in refi activity was expected. In the last two months, mortgage applications have collapsed 43.5%, according to Contingent Macro Advisors, far worse than anybody had anticipated. That is more than the 32% increase in average mortgage rates during the same time period. Refis now make up 67% of mortgage applications, still the anchor in the market despite the sharp increase in rates.

People aren’t going to buy a house unless they feel as if the asset price is sound, and it’s possible that people still think that housing prices remain inflated. The government hoped historically low interest rates would cause people to jump back in the market, and it did to a certain degree. But now that rates are on the rise, we are seeing a huge pushback from buyers — at a time when house buying should be at its peak for the year, just before school begins at the end of summer.

If the banks want to make up for the decrease in interest rates, they need to lower their credit standards to attract the people who would have never qualified at sub 4% interest rates. It is unclear if they are willing to do that. But if they don’t, they might come to regret ever pushing the government to raise rates.