What We Can Learn From The Stress Test

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 |  Includes: AXP, BK, C, COF, MET, STI, STT, USB, WFC
by: WideMoat Capital

If there is one conclusion that can be drawn from the most recent stress test performed by the Federal Reserve on the biggest banks in the United States, it is that they went from being under capitalized to now being over capitalized. The fact that most will still be above the required capital ratios, even if another huge recession were to hit the economy in the short to medium term, is simply impressive. Even the entities that failed to maintain their Tier 1 Common Ratio above 5% [Citigroup (NYSE:C), MetLife (NYSE:MET), Ally Financial and SunTrust (NYSE:STI)] were not that far from it, the only exception being Ally Financial:

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The banks with the highest ratios, State Street (NYSE:STT), Bank of New York Mellon (NYSE:BK), and American Express (NYSE:AXP) have very high capital ratios because of the nature of their businesses. In the case of State Street and Bank of New York Mellon, their business model is very focused in asset management and fiduciary services. Therefore most of the assets belong to their clients, who would be the ones to take a hit in the event of a crisis. As for American Express, most of their assets come from unsecured lending via credit cards, which normally require more capital to absorb possible losses.

With unemployment finally on a down trend, and house prices showing signs of stabilization, it is difficult to imagine some of the assumptions the Federal Reserve incorporated in the stress test actually happening. However, it is reassuring that even if unemployment were to hit 13 percent and housing prices to drop another 21 percent, that most banks would still have an adequate capital level. The following graphs better illustrate the kind of scenario the Fed wants the banks to be able to withstand, and what it means by an "extremely adverse" economic scenario:

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A jaw-dropping 13% peak unemployment is assumed, much higher than the peak 10% reached near the end of the financial crisis.

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The good news for those of us that missed buying shares below DOW 7,000 is that the Fed thinks it could be possible that we get the opportunity to invest near DOW 5,000.

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Considering that the combination of house price declines and extremely low long-term interest rates have already produced record housing affordability, a further 21% price decline would send home ownership affordability through the roof!

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The Figure above is interesting in that it shows how much each bank is expected to generate as pre-provision net revenue as a percentage of its asset base, which would serve as the first line of defense before the bank had to take a capital hit. American Express and Capital One (NYSE:COF) have high returns on their assets because both companies are very concentrated in credit cards which charge high interest rates. Perhaps more impressive were U.S. Bank (NYSE:USB) and Wells Fargo (NYSE:WFC), which despite being more traditional banks are still able to generate very high pre-provision profits.

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Another interesting graph shows that the Fed expects three companies to remain profitable even under such a bearish scenario. These are American Express, Bank of New York Mellon, and State Street. For those interested in more details, the Federal Reserve posted the report on their website.

The good news is that the Fed is now acknowledging that most big banks have fortress-like balance sheets and is allowing several to increase the amount of capital to be returned to shareholders. This in turn will make banks feel more comfortable making more loans and expanding their balance sheets, accelerating the pace of the recovery.

Disclosure: I am long BAC, WFC.