Banking Stress Test Results Not What They Seem
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With some fanfare, the Federal Reserve's “Stress Tests” have been released as concerned to the nation's largest bank holding companies. For most part, the numbers are open for all to peruse, and the purpose of this article is to point out that things are not quite what they may seem.
The popular press, upon the release of the 2013 results, hailed the improved health of most of the nation's large banks. Well, much of the improvement had more to do with a change of methodology than an explosive improvement in capitalization levels. I am going to look specifically at some of the themes demonstrated by the 2013 Stress Test.
The great loser, both last year and this year, is Ally Financial (NASDAQOTH: ALFI). This former GMAC is still 74% government owned as a vestige of last decade's government bailout extravaganza, and still faces enormous uncertainty due to its relationship with its former unit, Residential Capital, currently in Chapter 11 Bankruptcy.
Shockingly, its common ratio falls to a paltry 1.5% in the hypothetical economic crisis. That is even worse than the 2.5% under the slightly shallower hypothetical crisis in the 2012 stress test. The Federal Reserve obviously has little faith in Ally's primarily automobile related loan portfolio in an economically stressful environment. I have never looked carefully at Ally, and it is still too soon to look at this troubled former unit of General Motors as an investment option.
At this time last year, apart from Ally, the three most troubled large banks in the country, from capitalization standpoint, were SunTrust (NYSE: STI), Citigroup (NYSE: C), and MetLife. MetLife in particular is easy to dispense with as it is no longer a bank, having had its bank charter, which it first gained in order to take advantage of government largess in 2008, voluntarily relinquished in February, 2013.
A casual observation of stress test results shows that in 2012, SunTrust and Citigroup had bottom line common ratios of 4.8% and 4.9% respectively. Bottom line 2013 results showed the two banks had common ratios of 7.3% and 7.4%, respectively. In the 2013 test, the assumptions included draconian economic conditions, including a 50% drop in their equity portfolio values, a housing price decline of 20%, and a 5% drop in gross domestic product, among other conditions.
So did SunTrust and Citigroup really grow their common ratios by 250 basis points in one year? Of course not. The 2012 bottom line included the companies' capital distribution plans, whereas the 2013 test only dealt with common capital under an adverse scenario; capital returns would wait for another day. If the bottom line of 2012 had excluded planned capital returns to shareholders, SunTrust and Citigroup would have had 2012 common ratios of 5.5% and 5.9%, respectively, still impressive improvements.
Much of those two banks' capital improvements are due to the fact that they were either not allowed in 2012, or eventually chose not to return any capital to shareholders other than token dividends. There were no competitive yields, nor multi-billion dollar share buybacks. Therefore, the vast majority of Citigroup's $7.5 billion in 2012 profit, and SunTrust's $1.9 billion, flowed directly toward boosting capital. SunTrust's restructuring in September 2012 also aided its capitalization levels.
The biggest winners in the 2013, much like the 2012 stress test, were the nation's large trust banks. State Street and Bank of New York / Mellon, with Tier One Common ratios of 12.8% and 13.2% under the most adverse criteria. This strength befits their status as custodial banks, which in many ways form the backbone of the financial system of the United States.
In 2012, these two trust banks had common capital ratios, before distribution plans, of 13.3% and 15.1%, respectively. Note that the worst case economic conditions of the 2012 test were not as severe as the 2013 standard. American Express is the only other large bank holding company to achieve double digit capitalization in the 2013 test at 11.1%.
American Express's common ratio held up remarkably well in the hypothetical stress test, owing to its high quality underwriting in connection with its credit card business. Its lowest common ratio during the hypothetical economic crisis was just 160 basis points below its stated common ratio as of Sep. 30, 2012.
A few more losers
The biggest losers, other than Ally, were the investment brokerage banks. Due to the conditions of the hypothetical economic meltdown, Morgan Stanley's common ratio would fall from a stated 13.9% at the end of the 2013 third quarter to as low as 5.7%. Goldman Sachs' common ratio would fall from 13.1% to 5.8%. Compare those sorts of capital losses with a conservative bank like Fifth Third, whose common ratio would fall from a stated 9.7% to only as low as 8.6% under the adverse scenario.
Another large commercial bank without much of an investment bank presence, U.S. Bank also fared well. Its common ratio only declined by 70 basis points, from a modest 9% as of Sep. 30, 2012 to no lower than 8.3% in the hypothetical scenario. Even commercial banks with large investment banking arms fared not too well in the 2013 stress test. JPMorgan Chase, for instance, fell from a common ratio of 10.4% as of Sep. 30, 2012 to 6.8% under the adverse scenario. In this sort of stress test, it was the most conservatively run of banks that fared the best.
In coming days, the main result of this stress test will be the Federal Reserve's decisions on allowing dividend and share buybacks by the individual banks. It is obvious that JPMorgan will not be making any more ten billion dollar buybacks until it builds up more capital.
On the other hand, banks like the aforementioned Fifth Third, U.S. Bank, Citigroup, SunTrust, along with PNC Bank, and Regions Financial, are all positioned for moderate or substantial increases in their dividends or share buyback programs. I will be reporting on all these banks in turn as more information is released.
Max Fisher has no position in any stocks mentioned. The Motley Fool owns shares of Citigroup Inc . 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!