In the recently disclosed Comprehensive Capital Analysis and Review, otherwise known as the "stress test", two large commercial banks and a major insurer were the big losers, and along with Ally Financial, they were the only four of the 19 surveyed institutions to fail. But did they really fail? The only immediate repercussion of "failing" is that any planned return of capital to shareholders was denied, as these institutions must first raise more capital, hopefully, through retained earnings. But really, are Citigroup's (C) hypothetical 4.9% capital ratio and say, Keycorp's (KEY) 5.3% really much different? In my opinion, many of the passing banks, especially the larger, money centered banks have no business committing to substantial returns of capital to shareholders anyway.
The stress test's "draconian" assumptions were a 50% fall in equities prices, 13% unemployment, and a 21% drop in real estate prices. Do you think banks with large exposures in South Florida, like Suntrust Bank (STI) and Regions Financial (RF), would have welcomed only a 21% drop in real estate prices in the 2006 to 2010 period? I am going to take a close look at Citigroup's failure to pass, and also touch more briefly upon Suntrust and MetLife (MET), the other two "banks" in addition to Ally Financial, which failed the Fed's exam. All ratio measurements are to that institution's Tier One Common Capital Ratio.
The Fed is quite pleased with the banking industry. In the introduction to the stress test results, the Fed notes that the 19 banks would lose a combined $534 billion over a nine quarter period if the hypothetical financial meltdown occurred. But since the Fed clamped down on dividends and other capital distributions in 2009 through the end of 2011, the 19 banks had raised $339 billion of capital, for a total in their piggy banks of $759 billion.
Citigroup currently has an 11.7% capital ratio, higher than seven of the 15 institutions that passed the stress test. So perhaps it was a surprise to Citigroup that it failed the test. Assuming nine quarters of economic Armageddon, Citigroup's capital level would fall to 5.9%, a level still higher than Goldman Sachs (GS) (5.8%), Bank of America (BAC) (5.7%) and Regions (5.7%). But in its application to the Fed, Citigroup sought an enhanced dividend, stock buyback, or both, which if implemented, would drive the capital ratio down to 4.9%, a failing grade, by December, 2013.
I view Citigroup's narrow miss as a blessing of sorts to the company and its shareholders. It is not in any position to give up on improving the quality of its balance sheet. Citigroup has cast its lot into being a global financial enterprise, with particular emphasis on 150 cities around the world, and in particular, a focus on emerging markets. In 2011, 46% of main unit Citicorp's revenues, and 54% of its profits, were derived from foreign markets. This reliance on foreign activity is what probably caused Citigroup to fail the stress test, but it is also a business model too core to Citigroup's business to abandon.
Other issues, such as litigation, earnings restatements, and a 4th quarter of 2011 earnings disappointment are what weigh heavily on Citigroup's stock, not the fact that it barely failed the Fed stress test. Citigroup will undoubtedly resubmit its information to the Fed without the capital plan, and will receive a passing grade. Dividends and share buybacks can, and should, wait for another day. I have not been a fan of Citigroup for about six years, and now is not the time to jump on board. I would urge you to avoid Citigroup.
Suntrust also submitted what in retrospect was too aggressive a capital distribution plan to the Fed, and instead, failed the test as a whole. Its capital level, now at 9.3%, would fall, under the Fed's hypothetical economic crisis, to 5.5%. Taking into account Suntrust's dividend or share buyback plan, and the capital level would fall to 4.8% by the end of 2013, a failing grade. As a shareholder, I am pleased, as since my company foolishly sold its 88 year old interest in Coca Cola, Inc. (KO) in 2008, Suntrust stock has fallen by about 75% amidst a series of management missteps. Building up capital, to me, is the sanest and safest thing to do until Suntrust ramps up its earnings to traditional levels of over a one-percent return on assets.
The market did not judge Suntrust at all harshly for failing the Fed test. On the day after the announcement, in addition to questioning the Fed's methodology, Suntrust's Chief Financial Officer also stated management's expectation of an upside earnings surprise in the first quarter. I am expecting about $0.34 per share. Yet more important than the amount is that those earnings be from sustainable sources, meaning by something other than lower provisions for loan losses.
More than other "non banks" like Goldman Sachs or American Express (AXP), MetLife really does stand out in the Fed's list of 19 banks, for what Metlife is, of course, is the nation's largest life insurance company. It did not obtain a bank charter just to get TARP funds; it never asked for TARP funds. It owns relatively modest MetLife Bank, the nation's 35th largest bank with about $25 billion in assets, and the Fed judged MetLife as a whole, and not just the Bank, as a megabank for the stress test. MetLife is a mega insurance company, and to judge an insurer by bank standards seems rather absurd. This situation will soon enough resolve itself, as MetLife plans to sell its banking operations to General Electric (GE) to get itself off the Fed's radar. An overdue move if ever there was one. I do not see MetLife as a compelling purchase at this time, as it has had a substantial share price run up in the past few months. At a lower price, I might be interested in this front line insurer.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
