JPMorgan, Other Big Banks Juiced by Mid-Year Stress Tests

NEW YORK ( TheStreet) -- The nation's largest banks have sailed through yet another set of stress tests mandated by regulators, showing "the industry is well positioned to increase capital distributions" next year, according to Sterne Agee analyst Todd Hagerman.

Hagerman in a note to clients late on Monday wrote that "the bank-conducted stress-testing results, which extend through 2Q15, demonstrated continued improvement in the trajectory of core profitability, improved expected cumulative loss rates, and higher levels of core capital."

Investors may be confused to be reading about stress tests during the summer, since the largest banks have been undergoing the Federal Reserve's stress tests for the past few years in March, after which the group has announced capital deployment plans for the following year. The good news is that the big banks have come out of this round of tests looking considerably stronger than they did before.

Back in March, the Fed first conducted its annual Dodd-Frank Act Stress Tests (DFAST), to gauge the 18 largest US. Bank holding companies' ability to maintain minimum Basel 1 Tier 1 common equity ratios of 5% through a "severely adverse" economic scenario that included a 4% increase in the unemployment rate, which would have been "above any level experienced over the last 70 years." The severely adverse scenario also included an increase of corporate bond spreads to Treasury bonds of 550 basis points, real GDP declining by 5%, a 50% drop in stock prices and a 20% decline in home prices through the end of 2014.

The stress tests in March were based on September 2012 financial data, and showed that all 18 holding companies would survive though the end of 2014 with minimum Tier 1 leverage ratios of at least 5%, except for Ally Financial, the former GMAC.

One week after the DFAST results were announced, the Fed incorporated banks' capital return plans into another set of stress tests using the same scenario -- the Comprehensive Capital Analysis and Review (CCAR). All the banks passed CCAR, except for Ally Financial and BB&T ( BBT) of Winston-Salem, N.C., which had its capital plan rejected on "qualitative" grounds. JPMorgan Chase ( JPM) and Goldman Sachs ( GS) received "conditional" approval for their capital plans, but were required to submit revised plans to the Federal Reserve.

Despite only receiving conditional approval of its capital plan, JPMorgan during the second quarter was able to boost its quarterly dividend on common shares to 38 cents from 30 cents, while also announcing approval to repurchase up to $6 billion in common shares through the first quarter of 2014.

Self-Administered Stress Tests Look Very Good

Starting this year, the holding companies are required to make public disclosures of the results of their own stress tests by Sep. 30, using a new scenario provided by the Federal Reserve, based on March 31 balance sheet and off-balance sheet exposures.

The new "severely adverse" scenario provided by the Federal Reserve includes a 4% decline in GDP over six quarters, with the unemployment rate increasing to 11.7% over eight quarters. The new scenario also includes a 21% drop in home prices and a decline in stock prices of nearly 60%. The scenario also includes plenty of international economic turmoil. Under the new scenario, the banks would make their scheduled dividend payments, while ceasing common-share repurchases and only issuing new shares under existing employee compensation plans. Yes, executive gravy would continue to be ladled out.

JPMorgan Chase ( JPM) on Monday said that under its mid-year stress tests, the company would end up with a small pretax net loss of roughly $300 million for nine quarters through June 2015, with a minimum Tier 1 common equity ratio of 8.5%. The minimum Tier 1 common equity ratio under the latest stress test was up considerably from 7.6% in March.

Bank of America ( BAC) on Monday disclosed that its mid-year stress test results indicate the company would post pretax losses of $26.1 billion over nine quarters thorough June 2015 under the harsh new scenario, and that its minimum "hypothetical stressed" Tier 1 common equity ratio though the cycle would be 8.4%, which is up from the minimum ratio of 7.7% from the second round of Federal Reserve stress tests (CCAR) in March.

That's a very comforting increase for the nation's second-largest bank by total assets, which has been making a determined effort led by CEO Brian Moynihan to trim expenses and work through the huge portfolio of nonperforming mortgage loans and investors' loan repurchase demands, springing mainly from the acquisition of Countrywide Financial in 2008. The bank had previously estimated its losses under the Fed's previous severely adverse scenario would total $44 billion.

Wells Fargo ( C) fared even better, saying Monday that its mid-year stress tests showed its Tier 1 common equity ratio would decline under the new severely adverse scenario to a minimum of 9.9% through the second quarter of 2015, with cumulative pretax net losses of $3.8 billion. Under the CCAR in March, Wells Fargo's minimum Tier 1 common equity ratio was 8.3%.

Citigroup ( C) said that under its mid-year stress tests its minimum Tier 1 common equity ratio through June 2015 would be 9.1%, increasing from the 8.4% minimum projected by the Fed following the CCAR tests in March. Citi also said that under the new severely adverse economic scenario, its cumulative pretax net loss through the second quarter of 2015 would be $21.2 billion.

Goldman Sachs ( GS) said its Minimum Tier 1 leverage ratio under the new scenario would be 8.9%, with cumulative pretax net losses of $6.2 billion through the second quarter of 2015. The estimated minimum Tier 1 common ratio was up slightly from the minimum of 8.6% under the CCAR in March.

The Most-Improved Award goes to Morgan Stanley ( MS), which on Monday said its minimum Tier 1 common ratio under the Fed's latest severely adverse scenario through the second quarter of 2015 would be 9.5%, which is way up from the minimum of 6.7% under CCAR. The company also said that under the mid-year stress test scenario, it would post a cumulative pretax profit of about $600 million.

Atlantic Equities analyst Richard Staite in a note on Tuesday wrote that the latest round of stress tests "should give these banks confidence to apply to return more capital in 2014."

Looking ahead, the banks will be facing federal regulators' new leverage ratio requirements, which haven't yet been finalized, and won't be implemented until the beginning of 2015. Another unknown factor is what the Federal Reserve's March 2014 "severely adverse" scenario for its next round of stress tests will look like.

But these latest results are a clear indication that the "big six" U.S. banks "get it," as far as managing to regulators every-changing capital-strength expectations are concerned. According to Hagerman, "capital standards lack uniform harmonization and will likely increase over the foreseeable future, however ... today's relatively punitive capital levels will likely subside over time as the industry continues to build capital and the associated risks and economic landscape continue to change."

The excellent mid-year stress tests results underscore a possible long-term opportunity for investors. In light of the market hysteria over Federal Reserve monetary policy and the coming change in leadership at the top, along with such strong market gains this year and last, stocks of the largest U.S. banks may be quite volatile through the end of the year. But the group's valuation to forward earnings is still cheap on a historical basis, with valuations at roughly half their levels before the credit crisis hit in 2008:
  • JPMorgan Chase is the cheapest among the big six on a forward P/E basis, with shares closing at $53.14 Monday and trading for 8.7 times the consensus 2014 earnings estimate of $6.09 a share, according to analysts polled by Thomson Reuters. Since the company had already announced that its third-quarter legal expenses would be roughly $1.5 billion, sell-side analysts EPS estimates seem unlikely to be affected by the expected regulatory settlements this week.
  • Citigroup's shares closed at $51.00 Monday and traded for 9.2 times the consensus 2014 EPS estimate of $5.55
  • Bank of America closed at $14.53 and traded for 10.7 times the consensus 2014 EPS estimate of $1.36
  • Wells Fargo closed at $42.89 and traded for 10.7 times the consensus 2014 EPS estimate of $4.01
  • Goldman closed at $167.02 and traded for 10.8 times the consensus 2014 EPS estimate of $15.52
  • Morgan Stanley is the most expensive of the big six, at least for the time being, with shares closing at $28.73 Monday and trading for 11.1 times the consensus 2014 EPS estimate of $2.60

-- 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 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.