Should You Stress About The Stress Test?

Includes: BAC, C, JPM, MET, STI, STT, WFC
by: The Value Investor

The Federal Reserve Board pre-announced its results of the stress tests yesterday afternoon. This comes as JP Morgan announced a dividend increase and share repurchase plan triggering the Federal Reserve to release the results two days before originally planned.

Stress tests
The Federal Reserve Board obligates all bank holding companies in the US with assets exceeding $50 billion to be included in the yearly stress test. There are 19 US financial institutions which meet this criteria of which 4 have failed the test.

Ally Bancorp, Citigroup (NYSE:C), Metlife (NYSE:MET) and Suntrust Banks (NYSE:STI) are financial institutions which could not whether a shock in the national and global economy without seeing the Tier-1 capital ratio fall under 5%.

Assumptions of the test:
The assumptions of the stress test are reasonably harsh:
1. A severe US recession with a 8% quarter-on-quarter decline in real GDP in the first quarter of 2012. This is followed by a swift recovery as growth will be restored to 4% quarter-on-quarter by 2014
2. Unemployment will peak from 8.3% at the moment to 12.5% in the beginning of 2013
3. The Dow Jones Index will hit new lows of 5,500 in the end of 2012
4. House prices will continue to fall by another 20% until 2014

Market reaction
In the graph below you can find the returns of all 18 financial institutions which were involved in the test over a three-day period (Ally Financial is held privately).

The average three-day return of all 18 public banks was 4.4%. A good indication for the bullish sentiment is the fact that the three publicly listed institutions that failed the test still managed to return 1.7% on average.
The absolute winner was Bank of America (NYSE:BAC) which rose almost 10% as some market commentators were worried that it would fail the test. Metlife which failed the test is the only bank showing negative returns as it failed the test.

Return of Capital
It did not take banks long to announce dividend hikes and share buyback programs after getting approval from the Federal Reserve Board.

JP Morgan (NYSE:JPM) increased its quarterly dividend 20% to $0.30 per share, representing a 27% net payout ratio of 2011 net profit. On top of that the board of directors approved a $15 billion repurchase program, sufficient to retire 9% of its outstanding stock.

State Street (NYSE:STT) announced a 33% increase in its quarterly dividend to $0.24 per share for a payout ratio of 25%. It too announced a share repurchase program of $1.8 billion, or 9% of shares outstanding.

Wells Fargo (NYSE:WFC) more than doubled its quarterly dividend from $0.10 to $0.22 which makes Warren Buffet a very happy guy. Berkshire Hathaway owns over 400 million shares in the bank and will receive an annual dividend check of $360 million.

Discussion about the tests
While a severe global recession, a four-point rise in unemployment, the Dow Jones losing 50% and home prices falling another 20% are pretty unrealistic scenarios, some commentators argue that the FED is overlooking some areas:

  • The stress tests do not account for interest rate risk in any way. As the European sovereign crisis has demonstrated, interest rate risk can significantly impact the holdings of long term fixed rate assets.
  • Most of the estimated $534 billion in losses are related to credit cards, mortgages and commercial loans. A mere $116 billion is reserved for trading and counterparty losses. This seems reasonably low given the fact that the OTC market runs into the hundreds of trillions and the fragility of the European banking system.

The Federal Reserve got the results it wanted. Four banks have "failed" in the adverse scenario. If all institutions would pass, commentators would heavily criticized the test.

It is just months after the heights of the European debt crisis and yet the Federal Reserve Board already allows banks to reinstate generous dividends (with net payout ratio approaching 30%) and it approved major share buyback programs.

This way we will never learn.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.