Written by: Joe Cunningham

Edited  by: Nicholai Hill

Wall Street’s biggest headline yesterday was the release of notes from the latest Federal Open Market Committee’s (FOMC) meeting and the results of the Fed’s stress tests on America’s 19 largest banks. In the statement released by the FOMC, the Fed expects moderate economic growth over the coming quarters and expects unemployment to decline gradually but noted it is still elevated. The Fed also reiterated its federal funds target rate range of between 0 and 0.25% through late 2014. While the economic update was important, it was the results of the stress tests that generated the biggest buzz.

During the Great Recession, the Fed performed similar stress tests whose results displayed that both Merrill Lynch and Lehman Brothers were severely undercapitalized. Ultimately, Merrill was acquired by Bank of America and Lehman Brothers famously failed. The most recent results are much more uplifting, as 15 of the 19 banks tested passed and would be able to maintain capital levels above a regulatory minimum in an “extremely adverse” economic scenario, even while continuing to pay dividends and repurchasing stock. The four banks that failed at least one measure of the stress test were Citigroup, SunTrust Banks Inc., Ally Financial Inc., and MetLife Inc.

The standards used by the Fed are a source of controversy as they used a hypothetical scenario that was worse than any seen in the Great Recession. The new Fed stress test places more emphasis on systemic risk which is important in an increasingly global environment. More specifically, the test assumed an unemployment rate of 13%, a 50 % drop in stock prices and a 21 % decline in housing prices. Under those circumstances, banks would generate an aggregate loss of $534 billion over nine quarters. The U.S. unemployment rate is currently at 8.3% and reached a peak of 10 % during the Great Recession. The test conditions also assume that the 19 banks would see their Tier 1 common capital ratio, a measure of bank strength against loss, fall to 6.3% – above the required 5%, but well below the 10.1% level seen in Q3 2011.

So what does this all mean? American banks have been gradually becoming more stable as they have continued to stockpile capital since the financial crisis; however, they now have a conflict of interest. Andrew Slimmon, managing director of global investment solutions at Morgan Stanley Smith Barney says, “You have the Fed putting an approval rating on a lot of these banks saying: we’re comfortable with their financial position.” Strong banks and a sound financial system are the bases of the American economic recovery, but regulators are forcing banks to continue to bolster capital at a time when the economy would see a boost from more lending. Like the saying goes – you can’t have your cake and eat it too.

Given both the Fed’s affirmation of the strength of American banks and the overall cheapness of bank stocks, the Bryant Analysts are bullish on banks in the long-term. The increase in regulation will force banks to be more stable and thus better long-term buys. In the short and medium term, we see debt crisis in Europe as well as a point of concern (even with Greece getting upgraded to B- yesterday by Fitch and given a stable outlook). If investors are comfortable with high volatility in their bank holdings and can own them for an extended period of time, they are likely to be handsomely rewarded with substantial capital appreciation.

Contact the author: joe@bryantanalysts.com

Source: Bloomberg.com

Article Link:  http://www.bloomberg.com/news/2012-03-13/fed-says-15-of-19-banks-have-adequate-capital-in-stress-scenario.html