Fed Stress Tests Stress Bank Dividends (Update 1)

Updated with comments from FIG Partners analyst Christopher Marinac about SunTrust and Regions Financial.

NEW YORK ( TheStreet) -- Even the strongest among the large U.S. banks subject to the Federal Reserve's third round of stress tests will feature a severe set of economic assumptions that will likely put a damper on dividend increases for even the strongest of the big

The third round of stress tests will begin early next year, with the original group of 19 large U.S. banks -- including the "big four" of JPMorgan Chase ( JPM), Bank of America ( BAC), Citigroup ( C) and Wells Fargo ( WFC), as well as U.S. Bancorp ( USB), PNC ( PNC), Goldman Sachs ( GS), Morgan Stanley ( MS), and 11 other companies -- being joined by 12 more bank holding companies with over $50 billion in total assets, including Huntington Bancshares ( HBAN), Discover Financial Services ( DFS) Northern Trust ( NTRS), M&T Bank ( MTB), Comerica ( CMA), and Zions Bancorporation ( ZION).
Banks execs planning dividends will feel sharp pains following Fed stress testing.

The banks subject to the stress tests are required to submit their detailed 2012 capital plans -- including any plans to increase a return of capital to investors through increased dividends or share buybacks -- by January 9, and will have their plans approved or rejected by the Federal Reserve by March 15.

According to FIG Partners analyst John Rodis, "the metrics for the tests this time around will be a lot more stringent" than they were for the second round of stress tests earlier this year:
  • Gross domestic product declining 4% vs. 1.5%.
  • Unemployment reaching 13%, vs. 11%.
  • Home prices falling 21% vs. 11%.
  • Equity markets declining 52% vs. 27%.

Now that's a brutal set of economic assumptions.

"The good news," according to KBW analyst Frederick Cannon, "is that most large banks have increased capital levels significantly during the last year."

On the other hand, Cannon expects the stress tests "limit capital deployment at the stronger banks," as well as pressure weaker banks, including Bank of America and Regions Financial ( RF) -- which stands out among the largest publicly traded U.S. banks in owing $3.5 billion in federal bailout funds received in 2008 through the Troubled Assets Relief Program, or TARP -- into "more activities that improve capital ratios, but reduce earnings."

Cannon said that the Fed is being much more strict this time around in order to build credibility by taking the "contagion and risk to the U.S. banking system" from the European debt crisis into account, and making the U.S. tests "more credible than what is presented in Europe.

Bank of America famously had its capital plan rejected by the Federal Reserve earlier this year, with the regulator said no to an increased return of capital to investors. And that was before the company took an $8.8 billion second quarter loss. This time around, Cannon expects that the company will again "screen poorly," and that "If the Fed requires the banks to raise new capital, we believe BAC could be a likely candidate."

For JPMorgan, Cannon estimates a Basel 1 Tier 1 common equity ratio increasing to 11.4% by the end of 2012, with the company's Basel III ratio increasing to 9.2%. KBW estimates a "a $0.10 dividend raise to $0.35 per quarter in the second quarter of 2012, representing a 29% dividend payout ratio.

For Citigroup, which "currently carries an 11.7% tier 1 common ratio under Basel I, declining to an estimated 6.2% under Basel III primarily due to higher risk weightings within Citi Holdings," Cannon expects "a dividend raise to $0.30 per quarter from $0.01."

KBW forecasts that Wells Fargo will "double its quarterly dividend to $0.24 per share in 2012, which implies a payout ratio of 35% in 2012," however, since a payout ratio of over 30% will bring increased scrutiny by the Federal Reserve, Cannon said "our dividend assumption could prove to be aggressive under pressure in the stressed scenario." KBW is also projecting $2 billion in Wells Fargo share buybacks during 2012.

Looking at the 12 banks being brought into the stress test fold, Cannon sees the market questioning "the sustainability of the company's estimated 41% dividend payout ratio" for 2011," and "its ability to repay the remaining amount of TARP ($382 million) without having to raise additional capital," although the analyst also said the company "should be able to avoid having to raise additional capital."

For card lenders Capital One ( COF), American Express ( AXP) and Discover, Canon said that KBW feels "comfortable with the capital positions of the companies in our coverage and we see no risk of a capital shortfall under the new stress case assumptions."

Christopher Marinac of FIG Partners said that the Federal reserve's tough assumptions for the third round of stress tests were "no surprise," as regulators are looking to "keep a strangle hold on excess capital," adding that "there was a belief two years ago" that the first series of stress tests was "a take home test."

Marinac said that the stress tests were unlikely to keep SunTrust ( STI) from returning capital to investors through buybacks or an increased dividend during 2012, since the Atlanta lender's Basel III Tier 1 common equity ratio "will be pushing 10% if they do nothing during 2012."

For Regions Financial, quite a bit is riding on the company's continued attempt to sell its Morgan Keegan brokerage unit. "We'll have to see how it plays out," Marinac said, since it is still "really unclear" whether or not Regions will have to raise additional common equity through a public offering.

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

To contact the writer, click here: Philip van Doorn.

To follow the writer on Twitter, go to http://twitter.com/PhilipvanDoorn.

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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