State Street Sinks Financials Lower Amid Fed Rumblings

NEW YORK ( TheStreet) -- State Street Corp. ( STT) of Boston was the loser among major U.S. banks on Tuesday as shares sank 2.7% to close at $69.90.

Banks fared worse than the broad market on Tuesday as the KBW Bank Index ( I:BKX) dropped over 1% to 65.13 as Federal Reserve Bank of Dallas President Richard Fisher said in an interview on CNBC that he understood "full well" the sensitivity of investors to the eventual curtailment of the Federal Reserve's "QE3" bond purchases, but added "this program cannot go on forever."

"Every bond we buy comes back to us in terms . . . of excess reserves. Our balance sheet, of course, has become bloated," Fisher added.

Fisher went on to say that "the reports that are coming through, especially from the private sector . . . have been, on a cumulative basis, increasingly positive."

The Federal Reserve has been making net purchases of $45 billion in long-term U.S. Treasury bonds and $40 billion in agency mortgage-backed securities each month since September 2012 in an effort to hold down long-term interest rates. Stronger-than-expected numbers on Friday for U.S. job creation during October have once again raised fears among stock investors that the Federal Open Market Committee may decide to "taper" the central bank's bond buying. The FOMC next meets on Dec. 17 to 18.

Yellen's Ordeal Begins Thursday

Then again, there were plenty of negative items in the employment situation report on Friday, including a decline in the labor participation rate of 0.4% to 62.8%. "The civilian labor force was down by 720,000 in October," the Labor Department said. That underlines the case for a continued delay in tapering of bond purchases by the Fed.

Investors are also looking ahead to a Senate Banking Committee hearing Thursday, which will consider President Obama's nomination of current Federal Reserve Vice Chair Janet Yellen to succeed Ben Bernanke as the next Chairperson of the central bank.

It will be fascinating to see how Yellen navigates difficult questions from Republican members of the committee, including Senators Richard Shelby (R., Ala.) and David Vitter (R., La.). Vitter during an interview on Bloomberg TV last week said he wanted the Fed to take stronger measures to force the nation's largest banks to hold more capital. He also shared with Yellen his "concerns about this zero interest rate policy forever into the future. I am concerned that we're having little to no impact on the positive economic side, with diminishing returns on that sort of policy, but we are building up inflationary pressures, etc."

Most investors worried over Federal Reserve policy have been focused on the central bank's bond purchases. But Vitter was talking about the Fed's main policy tool -- the short-term federal funds rate, which has been kept in a target range of zero to 0.25% since late 2008.

The FOMC has repeatedly said it expects to continue this "extraordinarily accommodative" policy, assuming "inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal," at least until the U.S. unemployment rate falls below 6.5%. Despite the addition of 204,000 nonfarm jobs during October, the unemployment rate increased slightly to 7.3% from 7.2% the previous month, according to the Department of Labor.

Amid such a strong and extended bull market for stocks, any serious challenge during Thursday's hearing to the stimulus policies of Ben Bernanke, which have been strongly supported by Yellen, could cause a stir among stock investors.

State Street

Shares of State Street have returned 50% this year. The stock trades for 13.5 times the consensus 2014 earnings estimate of $5.19 a share, among analysts polled by Thomson Reuters.

State Street's return on average tangible common equity (ROTCE) for the 12-month period ended Sept. 30 was 17.70%, according to Thomson Reuters Bank Insight. That's an impressive figure, exceeded among KBW Bank Index components only by U.S. Bancorp of Minneapolis, with a 24.00% ROTCE of 24.00% and M&T Bank of Buffalo, N.Y., with an 18.57% ROTCE.

Please see TheStreet's earnings coverage for a discussion of State Street's third-quarter performance.

Following a meeting with State Street CEO Joseph Hooley and other senior managers of the company, KBW analyst Robert Lee in a client note on Nov. 4 wrote that "Regulatory uncertainty around capital was a focal point" for the bank, because of a change in the Federal Reserve's annual stress tests for large banks.

The annual stress tests are a two-part process. Following an analysis of banks' ability to whether a "severely adverse" economic scenario while remaining well-capitalized, the Fed will run a second set of tests -- called the Comprehensive Capital Analysis and Review (CCAR) -- incorporating the banks' plans for deploying excess capital through dividends, share buybacks and/or acquisitions.

A new twist for the banks during the 2014 stress tests will be a counterparty default scenario (CDS) that factors in the instant default of a bank's largest counterparty for trading of swaps and other derivatives.

This could cause State Street to be more conservative in how much of a capital return to investors the company submits for approval by the Fed.

"It was also clear that Supplemental Leverage Ratio (SLR) is a source of frustration for management, particularly if excess central bank deposits remain in the calculation," Lee wrote.

Following the 2013 CCAR in March, State Street announced regulatory approval to increase its quarterly dividend on common shares to the current 26 cents a share, and to buy back up to $2.1 billion in common shares through the first quarter of 2014.

Lee rates State Street "market perform" with a price target of $74, estimating the company will earn $5.25 a share in 2014, with EPS growing to $5.90 in 2015.

STT Chart STT data by YCharts

Interested in more on State Street? See TheStreet Ratings' report card for this stock.

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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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