4 Banks to Consider Following the Fed's Stress Test

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Unlike 2012, this year's Federal Reserve stress tests are a two-part affair. First, in early March, the Federal Reserve released this year's results, comparing the banks' common capital ratios at the end of the third quarter of 2012 with the likelihood that capital cushion would hold up given a draconian set of hypothetical economic calamities.

Then a few days later, the Federal Reserve would approve the condition or disallow any capital returns the banks' contemplated making to shareholders. It's only in this second step that we get a real picture of banks' health.

About a year ago, management at JPMorgan Chase (NYSE: JPM) preempted the Federal Reserve in announcing on its own that it had not merely passed the 2012 stress test, but had been permitted to engage in a massive stock buyback and raise its dividend.

The Federal Reserve placed a lot of trust in JPMorgan CEO Jamie Dimon and the rest of the management team, as even then the bank's common capital ratio was not particularly high.

In last year's test, with no dividend increase or other distribution of capital, JPMorgan's common capital ratio was just 6.3%. Regulators allowed the bank a 20% dividend hike and a share buyback worth another $12 billion or more.

These actions a year ago were calculated to further deplete JPMorgan's common capital ratio to just 5.4%. For a bank that touts its “fortress balance sheet” and is among the world's 29 banks considered “too big to fail,” I saw this expenditure as a leap of faith both by the bank's management and by the regulators who approved it.

Well, after the firm's 2012 profits were impaired by an over-$6 billion writedown due to the London Whale trading fiasco, which no doubt diverted management's attention for months, things only got worse.

The 2013 stress test found that JPMorgan's common capital ratio was 10.4% at the close of the third quarter of 2012. In the adverse hypothetical situation posited by the Federal Reserve, its capital level would fall to as low as 6.3% -- very much on the low end of the nation's large commercial banks.

In light of this, it was allowed only to pursue a share buyback of $6 billion in 2013, along with a 27% bump in the quarterly dividend to $0.38 per share. All of this was subject to efforts by JPMorgan to clean up some erroneous assumptions and valuations in its own capital plan. Goldman Sachs similarly had its capital plan approved with the condition that it “clean up” its assumptions in its own capital.

Shares of JPMorgan are up 10% over the past year, marginally trailing the S&P 500's 11.1% gain. It trades with a five year PEG of 1.27.

I like JPMorgan over the next three to five years. I don't love it because I have lost some faith in the effectiveness of its management, but there is no denying that this premier global powerhouse is a cash-generating machine. I look for earnings growth in the high-single digits annually over the next several years, and find this stock suitable for most income-oriented investors.

BB&T (NYSE: BBT)

For years a premier Southeastern powerhouse of a regional bank, BB&T has seen a rough go in recent weeks, triggering a 6% decline in its stock. Its own capital plan was flat out rejected by the Federal Reserve.

In recent weeks, BB&T announced it was changing the way it valued risk-weighted assets. Separately, in February, the bank took a $281 million charge as it readjusted its expectations surrounding a tax fight it is having with the Internal Revenue Service.

The Federal Reserve wanted to see just how the change in risk-weighted assets would play out before approving a capital distribution (see footnote 2 on page 23 of the report). This was a disappointment to most all observers, as BB&T had long been a conservative and profitable stalwart.

In 2012, earnings came to a solid 1.13% return on its nearly $180 billion in assets. I don't know with precision how the change in risk weighting will change things, but it will not affect the bank's profitability, which I see advancing in the low-double digits annually over the next several years. The current modest weakness in the share price is a good entry point for the long-term holder interested in current income and long-term capital gains.

SunTrust Banks (NYSE: STI)(NYSE: STI)

After steep losses last decade, SunTrust Banks is now dipping its corporate toes into its cash to reward shareholders. For the first time since the mid 2000s, it has announced a stock buyback program of a fairly modest $200 million over the next 12 months, as well as doubling its dividend to $0.10 per quarter.

These actions, after having failed the 2012 stress test, prove that a focus on profits and capital gathering over the past year had its rewards. If, as I expect, SunTrust shows further profit improvement in 2013, a more substantial return of capital could well be forthcoming in 12 months.

I am expecting the bank to reach the $3.00 per-share earnings level this year, as further reserve releases from SunTrust's provision for loan losses are likely in an improving credit environment. Unlike more successfully profitable banks, SunTrust still has plenty of room to decrease its expense ratios and increase its returns on assets. 

One top-ten-by-asset bank I'm starting to develop an interest in is Ally Financial (NASDAQOTH: ALFI). It announced the sale of its remaining mortgage portfolio of about $34 billion to Quicken Loans for $280 million. The deal is expected to close in the second quarter, pending regulatory approval.

The deal continues Ally's long-term alignment toward a low-risk, Internet-based retail bank with full service auto loan capabilities. Ally failed the stress test, yet a 74% stake owned by the U.S. government includes at least $5.9 billion of convertible equity, which, if converted, would have put Ally fully into the good graces of the Federal Reserve in the stress test. The government does plan to exit Ally by the end of 2014, and I will be keeping tabs on this bank in the interim.


Max Fisher has no position in any stocks mentioned. The Motley Fool owns shares of JPMorgan Chase & Co.. 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!

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