After The Stress Test, Should You Buy The Banks?
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The Federal Reserve just completed its latest round of ‘stress-testing’ the nation’s banks, to judge whether they can hold up should another economic recession take hold. Since the 2007 financial crisis that drove the United States into its worst recession in decades, the market has waited anxiously for signs that the country’s financial system has returned to health. There’s good news to be found within the results of the stress test, but more broadly, concerns still exist. That being said, is this truly your all-clear for buying the banks? Or, on the other hand, is a dose of caution warranted?
The Fed’s watchful eye
The Fed had set the Tier I common capital ratio, which measures a bank’s high-quality capital as a share of risk-weighted assets, at 5% or above to clear the current stress test. As per the Fed’s data, Citigroup's (NYSE: C) projected Tier I common capital ratio came in at 8.3% under hypothetical economic environment, with J.P. Morgan (NYSE: JPM) clocking in at 6.3%. Wells Fargo (NYSE: WFC) came in with a very solid 9.2% Tier 1 common capital ratio.
The stressful circumstances included unemployment rate reaching 12.1%, home prices plummeting nearly 21%, severe recession in the U.S., Europe and Japan leading to about 50% fall in equity prices, along with the U.S. GDP falling 6.1%. In all, the group of banks included in the Fed’s exercise would lose $462 billion in a downturn incorporating all of these factors.
The fact that 17 out of 18 banks, including Citi, J.P. Morgan, and Wells Fargo, passed this hypothetical test is likely to pave the way for the nation’s biggest banks to return cash to shareholders via increased dividends and share buybacks. Separate from the stress tests, it's critical to assess which of the banks have the operating results to back up the notion that they're worthy of your investing capital.
Focus on quality
Wells Fargo arguably performed the best of the nation’s big banks last year. The nation’s biggest mortgage lender reported record fourth-quarter net income that handily beat earnings expectations. Full-year net income was up 19 percent year over year; earnings per share for the entire year came in at a record $3.36. Revenue for the fiscal year clocked in at over $86 billion, up 6 percent from the prior year.
J.P. Morgan reported solid fourth quarter results of its own: revenues rose 10% on the strength of a 33% increase in mortgage originations. Earnings per share of $1.40 handily beat estimates of $1.16. Unfortunately, the firm’s trading fiasco known as the ‘London Whale’ resulted in a massive $6.8 billion trading loss last year. Going forward, the Federal Reserve intends on paying special attention to the strength of banks that have large trading operations, such as J.P. Morgan.
In January, Citigroup reported fourth-quarter results that widely missed expectations and underscored the company’s difficulties. During the quarter, Citigroup earned $2.2 billion, or 69 cents per share. Analysts had expected net income of $2.9 billion, or 96 cents per share. Revenue also disappointed, coming in at $18.7 billion, slightly below the $18.8 billion analysts had forecast. That hasn’t stopped shares from rallying, however, to its highest point since early 2011.
The best of the bunch
The banks have held their purse strings extremely tightly in the aftermath of the financial crisis, and if the Fed allows these banks to go ahead with returning additional capital to shareholders, further share price gains may occur. Now that it has passed the Fed’s latest round of testing, Citi has asked for $1.2 billion worth of share repurchases through the first quarter of 2014, but no change in its dividend.
My personal preference is oriented towards dividends as opposed to share buybacks, so from that perspective, Citigroup’s plan leaves a lot to be desired. Citigroup still pays only a token dividend of a few pennies per share, yielding only about one half of one percent. J.P. Morgan does pay a much bigger dividend of 2.5%, but I’d be lying if I said I weren’t concerned about the additional scrutiny the Fed plans on levying on banks with big trading operations.
As a result, that leaves Wells Fargo: a bank that doesn’t take huge lending risks, doesn’t have a massive trading business, and has a growing dividend. In addition to the highest Tier 1 ratio of the three banks in this article, Wells Fargo’s solid full-year 2012 results and 2.8% dividend make it the safest-looking bank of the group. As a result, it's the one I would favor if I were to invest in the financial sector.
Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Citigroup Inc , JPMorgan Chase & Co., and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!