Banks Stressing the System vs. Potential Winners of the TARP Repayment Race

The administration's draconian enforcement of bonus cuts for "distressed banks" has made Lloyd Blankfein and a slew of Wall Street executives hold their breath until they get the details of Geithner's stress test, in order to immediately repay their portion of TARP (although it is unclear if Warren Buffett will dump another billion or so into Goldman (GS) at this point). So what will be the likely metrics for the stress test and which banks will be able to pass the test, in order to be on their merry way to TARP repayment?

The rumored stress tests that may be utilized include:

i) tangible common versus assets

ii) tangible common versus risk weighted assets

iii) Tier 1 capital versus weighted assets

The complications arise when one considers the following facts:

• Flow of credit to the economy is flat, as bank balance sheets are not growing and new loan originations are down 50% (click on chart to enlarge)

• Tier 1 capital is at all time highs (click on chart to enlarge) while tangible common equity (TCE) is at all time lows (gating factor for balance sheet flexibility)

• Banks that can not pass the stress test and can not raise private capital will receive government preferred stock that can convert to common equity to preserve lending in a worse than expected economic envionrment.

• As the testing will initially apply to banks with more than $100 billion in assets, it is likely to extend to all banks that have TARP funding eventually. The initial cutoff was only established to keep the regulatory intervention manageable as the > $100 billion banks hold three quarters of the banking system's assets.

What do the probable stress tests imply?

Three tests are performed, one of which will likely be the version implemented by the administration.

i) Tangible common plus reserves plus pre-provision earnings less cumulative losses as a percentage of assets;

ii) The same as i but using risk weighted assets (RWA) as a denominator;

iii) The same as ii but using Tier 1 capital in the numerator;

The chart below presents the banking universe against each of the test scenarios and compares the ranking versus Q4 Non Performing Assets (NPA) and current P/Tangible Book.

Cumulative loss assumptions are: 25% for construction, 23% for credit cards (9% losses for 2.5 years), 14% for home equity, 12% for consumer excluding credit cards, 9% for first lien mortgages, 6.5% for commercial mortgages, 5.5% for commercial (C&I), 4% for all other loans and 1% for undrawn commitments. Peak unemployment is assumed at 9.5% and peak to trough housing price decline is at 40%.

Results: Banks which test better on average are trust banks such as a Bank of New York (BK) and Northern Trust (NTRS), JP Morgan (JPM) and PNC (PNC) due to big marks on acquired books (firesale purchases), and First Horizon (FHN), Comerica (CMA), City National (CYN) and KeyCorp (KEY) due to high tangible common. Banks testing poorly and have high NPAs include Citi (C), Zions Bancorp (ZION), SunTrust (STI), Fifth Third (FITB) and Huntington Bancshares (HBAN); also U.S. Bancorp (USB) and BB&T (BBT) do poorly on stress tests however that may be due to NPAs being below industry averages (click on charts to enlarge).



Instead of presuming what the tests will look like, it is possible to do a passive risk assesment in the form of a Texas ratio, or simply the ratio of NPA (loans and real estate) to TCE and Loan Loss Reserves.

As the resulting charts indicate (click to enlarge) the correlation between the Texas ratio underperformers and the at risk banks per the potential stress test, is very high. Worst scoring (highest risk) on the test are HBAN, C, STI, FITB and Marshall & Isley (MI), while CMA, PNC, JPM, Wells Fargo (WFC) and KEY score as lowest risk.



So what does all this mean for odds of which bank will be the first to be bathing in champagne? Most likely candidates are BK, Morgan Stanley (MS) and JPM, as these companies have high Tier 1 ex-TARP ratios (assuming 8% as a threshold). Other potential banks that could crawl out of the bonus grave include State Street (STT), NTRS, BBT and CYN. Furthermore, funding could be a consideration, but as banks are growing deposits twice as fast as loans since Lehman and compliments of $150 billion in TLGP funding, this would only be an issue for smaller banks. Banks below the threshold line are very unlikely to pay off TARP for the foreseeable future, meaning Vikram will likely be collecting $1 bonuses for many years to come.

Comments

[observation...:]

let's look at some data for loans OTHER than mortgage originations, which is what your "flow of credit to the economy" chart is. If you're going to stick with only mortgage origs, I'd like to see data on applications for mortgages as well. Conforming mortgage lending down 35%... what are applications for conforming mortgages doing? If they're down 35%, is it the banks that are the bottleneck?

Feb 17 02:50 PM

[Dana H.:]

observationalist: An excellent point. John Allison, former CEO and current chairman of BB&T, has made a similar point. Basically, he said that they can't give a loan to anyone who doesn't apply for one, and many of their commercial customers are so scared about the economy that they are not applying for new loans.

Feb 17 03:22 PM

[Larrysyr:]

Pushing the banks to repay TARP money sounds like a great idea.

Most of it is sitting in Fed deposits as excess reserves, anyway. If a bank can make a go of it off the government trough, let them go.

For the ones still needing public assistance, let them abide by public rules.

I'm not shedding too many tears contemplating Vikram's $1 paycheck.

Feb 17 03:39 PM

[helplessobs...:]

Mr. Market says BBT will have to pare its dividend, now 10% to the 5-6% range. This will free up several hundred millions of dollars that can be added to bank capital and make a strong bank even stronger. CEO King is most worried about unemployment >10% and its damage to his credit card loan book. He is least worried about his builders as they have to put up significant personal collateral to get a loan package.

Feb 17 05:25 PM

[RK:]

Anecdotally, in my small office, I know of 2 people who failed to refi their mortgages in the last 2 months due to drops in the appraised values of their houses. Conforming loans for under 20% equity are not to be had. Banks are scared to make bad loans (for now). Until housing values begin to stop falling and the mortgage rates come back down to 5%, the residential mortgage market won't lift.

Feb 17 06:09 PM

[everyotherc...:]

Very helpful analysis, Tyler! The weakeness I see is in the "cumulative loss assumptions" by product. I asume they are from the Barclays' study model. They are uniformly applied to all of the tested banks, yet there are vast differences in the underwriting practices of the banks-----witness the different loss experience we've seen in the various organizations.

There is a straight forward methodology to test underwriting and follow-up. It would involve assembling actual loss data product-by-product in trend form for each bank over a period of years; and delinquency and default data by product over the same period. Comparing the two trend lines for each bank would cry out for an easy algorhythm which could be applied discretely to each banks' product outstandings at 12-31-08 to project hpothetical future loss experience. Those projections can then be adjusted either way based on fuuture macro-economic assumptions.

Trust me, such an approach would reveal vast and real differences between the major banks.

Feb 17 08:34 PM

[jacks114:]

RK - Conforming Loans can be had up to 95%. ( with private mortgage insurance..) through both Freddie and Fannie. It is more likely that those in your office could not refinance due to poor equity positions that are at or above 100%. Many consumers spent the last 5 years consolidating and spending their home equity and now when they try to do the process all over again they find that they now owe more than their homes are worth....that is not a restrictive guideline issue, that is the bigger issue that all lenders are dealing with. If you were near 100% LTV 2 years ago, you are stuck now, period.

Feb 18 09:42 AM

[Stock Marke...:]

This is one of the best, most informative, and most useful posts I have seen on Seeking Alpha in 6 months. Nice work!

Feb 18 11:08 AM

[Christopher...:]

Tyler:

Good piece. You sure that the T1 capital series in the chart is correct? Tier One Risk Based Capital excludes many but not all intangibles. Are you subtracting the remaining intangibles to get tangible common? For example, Citi has $30bn in total intangibles in the lead bank. $20b is disallowed as part of T1 RBC. But there is still $10b in intangibles in T1 RBC, so I take out the remaining items.

Chris

Feb 25 09:38 PM