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

Updated with Stifel Nicolaus analysts Christopher Mutascio's comments on the Federal Reserve's 2013 stress test scenarios.

NEW YORK ( TheStreet) -- For its next round of stress tests for the 19 largest U.S. bank holding companies, the Federal Reserve has introduced some new twists, but also thrown a gift to the banks that may face rejection of their initial plans to return capital to investors.

For the largest bank holding companies, the annual stress are called the Comprehensive Capital Analysis and Review, or CCAR.

Companies that had their initial 2012 capital plans in March rejected in full or in part, including Citigroup ( C), SunTrust ( STI) and Fifth Third Bancorp ( FITB), had to wait until August for their revised capital plans to be approved. Of the three, only Fifth Third was approved in August for a dividend boost. Neither Citi nor SunTrust requested a dividend increase or share buybacks in their revised 2012 capital plans.

During the next round of stress tests, banks with capital plans rejected by the Federal Reserve will receive feedback during the stress test process and can lower their capital return plans before the Fed approves or rejects the capital plans, increasing the chances of modest -- or better -- returns of capital to investors.

According to Credit Suisse analyst Craig Seigenthaler, this "one-time adjustment" option will enable banks whose initial 2012 capital returns were rejected, as well as banks like Regions Financial ( RF) and Zions Bancorporation ( ZION) -- both of which in 2012 repaid government bailout funds received in 2008 through the Troubled Assets Relief Program or TARP -- to present more aggressive plans to return capital during 2013 than previously expected.

For the 2012 stress tests conducted during the first quarter, the Federal Reserve used an "Adverse Scenario" that included real U.S. 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 fell 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, "foreign real GDP growth was also assumed to contract, with growth slowdowns in Europe and Asia in 2012."

In order to have their capital plans approved the banks subjected the stress tests had to show that their estimated Tier 1 capital ratios at the end of 2013 would remain above 5%, "with all proposed capital actions through Q4 2013."

For the next round of stress tests, the Fed requires bank holding companies to show that they can maintain a "Tier 1 common ratio of 5 percent on a pro forma basis under expected and stressful conditions throughout the planning horizon," which includes a far less severe Adverse Scenario than the previous round of stress tests, but also includes a new "Severely Adverse Scenario."

Adverse Scenario


The 2013 adverse scenario "features a moderate recession in the United States that begins in the fourth quarter of 2012 and lasts until early 2014; during this period, the level of real GDP declines 2 percent, and the unemployment rate rises to 9¾ percent." The adverse scenario also includes CPI inflation rising to 4% and equity prices dropping by 25% through the middle of 2013, with home prices declining "more than 6 percent during 2013, and commercial real estate prices falling 4½ percent during 2013."

Also under the new Adverse Scenario, short-term rates rise from their current range of between zero and 0.25% in order to combat inflation, reaching 2.5% by the end of 2013, while "the yield on the long-term Treasury note increases by less but still rises above 3½ percent by the end of next year; thus, the yield curve is both higher and flatter in 2013."

Adding further to the misery under the Adverse Scenario, mortgage rates rise, while "corporate borrowing rates also move significantly higher, to more than 7 percent by the end of 2013, despite only a modest increase in spreads."

Severely Adverse Scenario


The Fed's new severely adverse scenario is similar to the 2012 adverse scenario, but nastier in some ways. "In the United States, the severely adverse scenario features a severe recession, with the unemployment rate increasing 4 percentage points from current levels (an amount similar to that in severe contractions over the past half-century). Notably, the unemployment rate remains above any level experienced over the last 70 years from the middle of 2013 to the end of the scenario."

The Federal Reserve also said that under the severely adverse scenario, domestic real GDP declines by almost 5% between the third quarter of 2012 and the end of 2013, with inflation slowing to 1%. Equity prices fall by over 50%, while housing prices and commercial real estate prices plunge by more than 20% by the end of 2014.

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 essentiallyunchanged 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 lastyear, 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.

>Contact by Email.

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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