Bank Stress Tests are Cruel, But Fair: Street Whispers (Update 1)

Under the severely adverse scenario, "short-term interest rates remain near zero through 2015," while "the yield on the long-term Treasury note declines to 1¼ percent in 2013 before edging up about 1 percentage point by the end of 2015. Spreads on corporate bonds ramp-up to 550 basis points over the course of 2013. As a result, despite lower long-term Treasury yields, corporate borrowing rates rise and reach a peak of 6¾ percent in mid-2013."

Meanwhile, "the international component of the severely adverse scenario features recessions in the euro area, the United Kingdom, and Japan and below-trend growth in developing Asia," with the eurozone slipping "into recession in the fourth quarter of 2012 and [remaining] in this state until the end of 2013." According to various reports, the eurozone has already slipped into a recession.

The Fed said that "the main qualitative difference between this year's supervisory severely adverse scenario and last year's supervisory stress scenario is a much more substantial slowdown in developing Asia," including "a sharp slowdown" in China. "This feature of the scenario is designed to assess the effect on large U.S. banks of the important downside risks to the global economic outlook that could result from a sizeable weakening of economic activity in China," the regulator said.

Stifel Nicolaus analyst Christopher Mutascio said on Friday that "It appears that the Fed's worst case scenario implies a less severe recession than last year's CCAR," because under the severely adverse scenario, "the Fed assumes a trough real GDP growth rate of -6.10. This compares to a trough of -7.98 in last year's stress test." Then again, "the peak real GDP growth assumption is essentially unchanged at 4.60%. So, it looks as if the Fed has eased the severity of a recession in the most stressed scenario but it does not translate into a more robust recovery than originally assumed."

Mutascio also said "we caution investors in reading too much into the assumptions used by the Fed. It has not been a historically good prognosticator, in our view. For example, in the 2013 CCAR Baseline assumptions, the Fed assumes the Dow Jones Industrial average will be 15,180 by the end of 4Q12. That would represent a 21% increase over the next six weeks."

Jefferies analyst Ken Usdin said that "The Fed's worst-case economic / market scenario for the 2013 stress test looks fairly comparable to previous years, giving us confidence" that banks' capital plans will be approved.

Usdin added that "Our model shows banks faring better than last year, with no bank in our universe breaching the 5% Tier 1 common ratio minimum in our initial run. Better results are a function of another year of earnings and capital growth layered against a fairly similar stressed scenario."

Even with this year's mulligan feature (the ability to revise capital requests lower one time)," Usdin said that banks are likely to keep capital ratios flat-to-growing this year given ongoing macro uncertainty. Currently, the only bank in our universe that we expect to pay out more than 100% of earnings in 2013 is [State Street (STT)].

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-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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