Banking Stocks: Does Better Performance In Stress Tests Mean A Better 2013?

Includes: BAC, C, FNMA, JPM, WFC
by: Fusion Research

The recently released Federal stress test results for the country's largest financial institutions, presented a favourable picture on the U.S. banking sector. Most of the big banks have passed the test, proving their ability to sustain in a crisis. The banks also released their numbers from their internal stress test models to compare it with that of Fed's. Citigroup, Inc. (NYSE:C) was leading the race with the closest match, followed by a few banks including Bank of America Corporation (NYSE:BAC). On the other hand, institutions like JPMorgan Chase & Co. (NYSE:JPM) and Wells Fargo & Company (NYSE:WFC) showed highest discrepancy when compared to Federal's results. Since then, the big banks are grabbing all the media attention with their positive score-cards. Did the banks really strive hard to improve their capital position or the test was too easy to pass - this still remains open for discussion. However, in this article I have analyzed above three banking stocks and two of them present an strong investing opportunity. Let's discuss them in detail.

Bank of America - Reaping the harvest of hard work!

In 2012, Bank of America (BoA) was much behind its competitors such as JPMorgan Chase and Goldman Sachs. However, this year the company has posted better capital levels than these two. The tier 1 common ratio for BoA stood at 6.8%, which was decently above the Fed's minimum requirement of 5%, but far below Citigroup's 8.3%.

Bank of America's huge improvement from the previous year's results clearly shows that the CEO Brian Moynihan's efforts have started paying off well. Also, its new projects are on track to deliver similar performance in the future. The 'project new BAC' is one such initiative, which aims to save around $5 billion in costs every year, since its launch in 2011. This is a two-phase initiative to align the company's business processes to save costs and increase its revenue. Phase one of the initiatives focuses on consumer business & technology and operations, and has the goal to reduce around 30,000 positions. These cuts are expected to be completed by the end of 2013, which will also complete the phase one with a saving of $5 billion by 2013. In 2012, BoA also started phase two initiatives, which will result in cost savings of $3 billion by mid of 2015.

However, BOA's mortgage issues are still lying in the background, which is going to be a headwind for the company. Though, the company has made great efforts in this regard too. In January, 2013 the company entered into an agreement with Fannie Mae (Federal National Mortgage Association) with a purpose to settle all outstanding claims relating to residential mortgage loans. This covers loans sold to Fannie Mae (OTCQB:FNMA) from January, 2000 to December, 2008, including the repurchase of 30,000 loans by BoA. These loans will be purchased for approximately $6.75 billion, along with a cash payment of $3.6 billion to Fannie Mae. I believe this is significant step for the company to resolve its pending issues, along with the process simplification and cost reduction in the coming years.

The steps ahead

After all these efforts, the main question which remains in front of the investors is whether BoA will be able to announce any buybacks or dividend now? The 17 banks, which have a capital ratio above 5%, have the advantage to change their capital plans following approval from the Federal Reserve.

BoA hasn't declared anything as of now, but I feel it will follow the footsteps of Citigroup, which has recently announced a buyback of $1.2 billion over the next one year which is pending approval from Fed. This came in as big news for its investors, as it is the highest return announced since last six years, following which the shares jumped around 1.6%. Even last year, Citigroup was on the lookout for Federal's permission to return some money to its shareholders but it was rejected by the regulator. However, this year the company is highly positive that the proposed buyback will be approved. Citigroup is already outpacing the Standard & Poor's 500 financials index of 11% with its 14% return in 2013. And following the approval, I feel the stock is set for more upside growth.

On the contrary, the Fed results brought some mixed emotions for JPMorgan's shareholders. The company had a discrepancy of around 130 bps in tier 1 common ratio as compared to Federal's model. In spite of its global reach, JPMorgan is closely related to the American consumer which comprises 65% of its loan losses. In 2012, the company sailed through the stress test and returned around 21% to its shareholders. However, the troubling events in 2012 have put a dent on the company's reputation of generating good returns for its shareholders. It would be really interesting to see whether JPMorgan increases its dividend and buybacks, keeping itself on the track.

Investor's takeaway

The banking sector presented a slightly better picture in 2012 as compared with 2011. Even though the economic uncertainties still continue, the banks are seriously responding to every regulatory pressure. This has made the banks more competent to face the future challenges. There are some near to mid-term headwinds in the banking sector due to various structural changes. But the industry looks stable and secure from the long-term perspective.

Additionally, the Federal Reserve's authorization on dividend increases and buyback programs will further attract investor's attentions towards this sector. Based on the Fed results, I believe the average payout ratios will increase from 43% to around 57%. This will direct around 35% of the excess capital over the minimum requirement of 5% towards the investors' return. This bodes well for Citigroup and Bank of America. Therefore, I am bullish on both these stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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