This Is the Bank Stress You Asked For (Update 1)

Updated with the Federal Reserve's movement of the stress test results announcement to Tuesday, JPMorgan Chase's announcement, and test results for Bank of America and Citigroup.

NEW YORK (TheStreet) -- Investors were thriled on Tuesday after JPMorgan Chase ( JPM), announced it had passed the Federal Reserve's latest round of stress tests, but U.S. citizens should be proud of way the central bank is handling this regulatory role.

The Fed is required under the Dodd Frank Wall Street Reform and Consumer Protection Act to conduct an annual Comprehensive Capital Analysis and Review (CCAR) on large, complex bank holding companies.

The 19 companies required to participate in this year's CCAR submitted capital plans, including any plans to increase their returns of capital to investors through dividend hikes or repurchases of shares.

The Fed takes each company's "unique risks" into account and make sure each has "sufficient capital to continue operations throughout times of economic and financial market stress."

Most of the recent business coverage has focused on what is of the greatest concern to investors -- higher dividends and support for share prices through buybacks -- and for many of the stress tested banks, dividend increases are just around the corner. But a closer look at the Federal Reserve's testing methodology shows that the regulator is doing all of us a huge favor.

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Many of the regulatory changes springing from Dodd-Frank have been ridiculed, including the Volcker Rule, and its ill-defined ban on "proprietary trading," which is causing a talent exodus from major banks, including JPMorgan Chase as investment managers and buy-side analysts leave in droves, as the banks wind-down their private equity investing and become less competitive internationally.

Another deserving target for scorn is the farcical Dodd-Frank mandate that large banks and bank holding companies draw up resolution plans for a rapid resolution of their assets, in the event of failure. These "living wills" can't work, because in a stressed and illiquid market, there won't be any quick buyers the assets of a systemically important bank that is failing.

After Tom Brown of Second Curve Capital said in December that he had suggested to Bank of America board of directors member Chad Gifford that the company consider selling part of its branch network -- with the company's Texas operations given as an example -- as a way of showing the market that the company's assets really were worth more than the fraction of book value the stock was trading for, the Wall Street Journal on Feb. 17 reported that the company might indeed consider a Texas sale if it were to come under severe stress.

According to the Journal report, Bank of America would consider selling its Texas branches, along with its U.S Trust wealth management subsidiary, it the company were forced to raise capital "in a market shock or severe economic downturn." Right after the Journal story was published, Brown said "the next time major panic occurs, these crazy contingency plans/living wills/whatever they're commanding the big banks to come up with will turn out to be useless," since, "by the very nature of market shocks--by definition, really-- there are no buyers. The italics are Brown's.

Getting back to this year's stress tests, the Federal Reserve has built credibility into the process, by testing bank holding companies' ability to maintain minimal Tier 1 common equity ratios of at least 5%, under "a severely adverse macroeconomic scenario."

How severe?

For starters -- keeping in mind that the unemployment rate remained at 8.3% in February and that the U.S. economy is growing -- the Fed's adverse scenario includes the real GDP contracting "sharply through late 2012, with the unemployment rate reaching a peak of just over 13 percent in mid-2013," while also assuming "that U.S. equity prices fall by 50 percent from their Q3 2011 values through late 2012 and that U.S. house prices fall by more than 20% through the end of 2013." In addition, under the Fed's adverse scenario, "foreign real GDP growth is also assumed to contract, with growth slowdowns in Europe and Asia in 2012."

The adverse scenario includes much higher unemployment than we have seen during this terrible economic cycle, and an additional 20% drop in U.S. housing prices is rather difficult to envision. The Fed's adverse scenario is very aggressive, as it should be, in order to make the stress tests meaningful.

The Federal Reserve on Tuesday publicly announced the stress test results, after JPMorgan forced the regulator to move up its schedule, after announcing it had passed the tests and that it would raise its quarterly dividend by a nickel to 30 cents, and also that it had authorized $15 billion in share buybacks.

The Fed's test results included the "minimum stressed capital ratios assuming no capital actions" after the first quarter of 2012, as well as the minimum stressed ratios assuming that each stress-tested bank follows through with its planned return of capital to investors.

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For Bank of America and other large mortgage loan servicers, including JPMorgan Chase, Wells Fargo ( C), Citigroup ( C) and Ally Financial, the stress tests include hypothetical mortgage putback losses, based on the real information provided by the holding companies, but factoring in that brutal additional 20% housing price drop included in the adverse economic scenario.

Bank of America didn't included plans in its stress test submission to return capital to investors this year, for the obvious reason that its ultimate risk from mortgage putback claims is still unknown.

According to the Fed's stress test announcement, Bank of America's estimated Tier 1 common equity ratio under the stressed economic scenario would be 5.7%, and and estimated 5.9% at the end of 2013. So Bank of America passed the stress tests, much to the relief of investors, who sent the shares up over 6% to $8.49 on Tuesday, after the Wall Street Journal said the company had passed.

KBW analyst David Konrad had said in a report on Monday that he expected Citigroup to be permitted to raise its quarterly dividend payout from a penny to a nickel, but also forecasted that the company would not repurchase any shares during 2012.

Konrad called Citi's potential for deployment of excess capital "one of the greatest uncertainties in the group heading into the week," and also said that part of the Fed's approval of the company's plans, "may also include the redemption of approximately $3 billion of trust preferred securities currently owned by the FDIC and U.S. Treasury."

While Citigroup's stress-tested Tier 1 capital ratio was estimated by the Fed to be 5.9% with no additional return of capital, the Fed said that if Citi were to rturn capital as it had requested the Fed's permission to do, its Tier 1 ratio would slip to 4.9% at the end of 2013. So Citi's full capital plan failed the stress test, but it remains to be seen if the company has received permission for any additional capital return to investors.

Holding companies still owing government bailout funds received through the Troubled Assets Relief Program, or TARP -- including Regions Financial ( RF) -- are expected soon to announce how much capital they will be required to raise in order to repay the government and exit the costly bailout program, with, of course, their plans and permissions incorporating the adverse economic scenario.

Kevin L. Petrasic -- a partner in the Global Banking and Payment Systems practice of Paul Hastings, in the firm's Washington, D.C. office -- says the stress tests, "are very meaningful," as the "banks are demonstrating their ability to withstand remarkably dire economic consequences," and that "We should take some comfort in the rigor with this the Fed is holding the tests."

Petrasic adds that "as one of the largest economic powers, we need institutions that can support the type of economy and competitiveness that the U.S. has thrived upon over the past century, assuming we don't eviscerate the ability for the largest U.S. banks to remain competitive internationally."

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"If we cut off the ability of the largest U.S. financial institutions to do certain things, Petrasic says, "all of that capital now focused on the U.S. is going to go someplace else where it has a freer home and much greater latitude. There's an art to supervision, and you have to let institutions do what they are good at, including taking some risk."

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

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

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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 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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