Why You Should Celebrate Bank Stress Tests

NEW YORK (TheStreet) -- The Federal Reserve will announce the results of its annual stress tests for major U.S. bank holding companies on March 20, but bank stock investors are looking ahead to March 26, when the regulator releases results of its annual reviews of the banks' plans to return capital to investors.

While "stress tests" is the term that dominates the headlines, the Comprehensive Capital Analysis and Review (CCAR) is the more important event, because most of the nation's largest banks will follow up that announcement with their own announcements of plans to deploy excess capital through the first quarter of 2015. Most of the capital deployment will come in the form of dividend increases and share buybacks. Most of the big banks have been reducing their count of outstanding shares through buybacks over the past few years, which boosts earnings-per-share, supporting higher stock prices.

The stress tests are based on Sept. 30 financial reports and gauge the banks' ability to remain well-capitalized, with minimum Tier 1 common equity ratios of 5%, through a "severely adverse" economic scenario. This year's scenario assumes an increase in the U.S. unemployment of four percentage points, with the unemployment rate peaking at 11.25% in mid-2015. The scenario also includes a decline in real U.S. GDP of nearly 4.75% through the end of 2014, a 50% decline in equity prices and a 25% decline in home prices.

So investors and taxpayers can take some comfort that the Federal Reserve, at least, believes banks passing the tests won't need to be bailed out if quickly we enter another financial crisis.

One major addition to this year's stress tests is that banks considered global systemically important financial institutions (G-SIFIs) will incorporate a counterparty default scenario that "involves the instantaneous and unexpected default of the bank holding company's counterparty with the largest net stressed losses." In other words, the stress tests will factor in the instant default of a bank's largest counterparty for trading swaps and other derivatives.

U.S. G-SIFIs include JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), Goldman Sachs (GS), Morgan Stanley (MS), Bank of New York Mellon (BK) and SunTrust (STI) of Atlanta.

Also new to the 2014 stress tests is a "Global Market Shock" component of the severely adverse economic scenario, which the Federal Reserve describes as "one-time, hypothetical shocks to a large set of risk factors."

Analysts expect most of the banks subject to the stress tests to "pass," the stress tests. When the results of the 2013 stress tests were announced in March of last year, the only bank holding company not making the grade by showing the ability to maintain a 5.0% Tier 1 common ratio through that test's adverse scenario was Ally Financial, the former GMAC, which is majority-held by the U.S. government, which has received $12 billion in federal bailout funds through the Troubled Assets Relief Program, or TARP.

And Now, the Goodies

The Fed will announce the CCAR results at 4 p.m. ET on March 26. Most of the banks subjected to the capital plan reviews are expected to announce their own capital deployment plans right after the regulator's announcement. The capital plans run from the second quarter of 2014 through the first quarter of 2015. Last year's CCAR included the 18 banks subject to the Fed's stress tests. This year's CCAR will be expanded, to include regional banks with total assets of more than $50 billion, which were previously included in a different program called the Capital Plan Review, or CapPR.

Following the 2013 CCAR, only BB&T (BBT) of Winston-Salem, N.C., had its capital plan rejected, which the Federal Reserve said was based on "qualitative" factors. BB&T was required to submit an updated capital plan, which was approved by the Fed in August, but included no dividend increase and no share buybacks through the first quarter of 2014.

For simplicity, let's refer to the period running from the second quarter of 2013 through the first quarter of 2014 as "CCAR 2013," and the period running from the second quarter of 2014 through the first quarter of 2015 as "CCAR 2014."

But two other companies -- JPMorgan Chase -- and Goldman Sachs -- received "conditional approval" to their capital plans, pending acceptance by the Fed of revised capital plans. Both companies had their revised plans approved in August.

For CCAR participants covered by his firm, KBW analyst Brian Kleinhanzl expects increased returns of capital through dividends and stock buybacks. "[W]e forecast the median net payout ratio will increase to 68% of earnings," Kleinhanzl wrote in a note to clients on Sunday. Net payout ratio in this case means dividends plus buybacks, as a percentage of earnings. Some analysts prefer to reserve the term "payout ratio" for just dividends over earnings.

Bank holding companies expected by KBW to be approved for combined capital deployment of at least 75% of earnings include State Street (STT), KeyCorp KEY of Cleveland, Comerica (CMA) of Dallas, U.S. Bancorp (USB) of Minneapolis, American Express (AXP), Fifth Third Bancorp (FITB) of Cincinnati, and Discover Financial Services (DFS).

"Given the changes to the CCAR process this year, we believe there could be some downside in our CCAR assumptions for specific companies. Companies where our capital return assumptions may be too high include [Citigroup], GS, JPM, STT, and [Bank of New York Mellon (BK)]. Companies where our capital return assumptions may be too low include [Morgan Stanley]," Kleinhanzl wrote.

KBW estimates Citigroup will in increase its quarterly dividend to a nickel a share from a penny, in the second quarter, and for Citi to be approved for up to $7.619 billion in share buybacks for CCAR 2014, with no buybacks for CCAR 2013. That makes for a total estimated capital deployment of $8.212 billion, or 57% of CCAR 2014 earnings.

For Goldman, KBW expects approval for a dividend increase by a dime to 65 cents, and for the company to be approved for $4.163 billion in share buybacks, increasing from estimated net buybacks of $2.896 billion for CCAR 2013. The lower 2013 figure includes the issuance of over $2 billion worth of common shares when Berkshire Hathaway (BRK.B) exercised a warrant left over from that company's $5 billion preferred investment in Goldman at the height of the financial crisis in September 2008.

KBW estimates JPMorgan Chase will be approved to raise its quarterly dividend to 41 cents for 38 cents, and for the bank to be approved by the Fed for up to $6.33 billion in share buybacks for CCAR 2014, up from an estimated $1.756 billion in buybacks during CCAR 2013. JPMorgan was approved for $6 billion in buybacks last year, but the company faced many legal and regulatory hurdles during 2014. The bank reported a third-quarter net loss as it built litigation reserves ahead of $17.5 billion in residential mortgage-backed securities settlements with government authorities and private investors during the fourth quarter.

For State Street, KBW estimates the dividend will remain 26 cents a share, with the custody bank approved for $1.620 billion share buybacks, down slightly from an estimated $1.676 billion during CCAR 2013.

KBW expects Bank of New York Mellon to raise its dividend to 17 cents from 15 cents, and to be approved for $1.091 billion in buybacks for CCAR 2014, up from an estimated $901 million in buybacks during CCAR 2013.

Moving on from the five banks for which KBW's capital deployment estimates may be too high, KBW's conservative estimate -- in the opinion of Kleinhanzl -- for Morgan Stanley includes an increase in the quarterly dividend to 7 cents from 5 cents, and approval for $2.508 billion in buybacks. That's up from an estimated net issuance of common shares totaling $570 million during CCAR 2013.

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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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