Banks' Excess Capital Is 'Absolutely a Reality'

NEW YORK (TheStreet) -- There are two big days coming up this month for bank stock investors, which will underline large U.S. banks' continued increase in excess capital, according to Oppenheimer analyst Chris Kotowski.

The Federal Reserve on March 20 will announce the results of its annual stress tests on 30 major bank holding companies, which is an increase from the group of 18 that has been tested over the previous several years. The tests are based on Sept. 30 financial statements, and are meant to gauge the banks' ability to remain well capitalized 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.

The only bank to fail last year's stress tests was Ally Financial, the former GMAC, which still has the majority of its common shares held by the federal government.

Following the completion of the stress tests, the Federal Reserve will run a second set of tests to incorporate the banks' plans to deploy excess capital through dividend increases, share buybacks and acquisitions. This part of the process is called the Comprehensive Capital Analysis and Review (CCAR).

Only two banks had their capital plans rejected outright by the Fed last year -- Ally Financial and BB&T (BBT) of Winston-Salem, N.C.. The regulator cited "a qualitative assessment" in its "objection" to BB&T's capital plan. A revised plan from BB&T was accepted by the Fed in August, but included no dividend increase or share buybacks through the first quarter of 2014.

JPMorgan Chase (JPM) and Goldman Sachs (GS) both received "conditional approval" for their 2013 capital plans, and both companies had revised plans accepted by the Federal Reserve in August.

Kotowski, in a note to clients on Monday, wrote that for the 11 large-cap banks covered by his firm, the aggregate Basel III Tier 1 common equity ratio rose to 10% at the end of 2013 from 9% a year earlier, even after the banks had made dividend payments and stock repurchases totaling "52% of actual 2013 earnings."

For 2014, Kotowski expects the banks to return about 65% of "run-rate" earnings to investors through dividends and buybacks, while seeing their aggregate Basel III Tier 1 common equity ratio climb to 10.5%.

"The point we would take away is that in years past excess capital was hypothetical; this year it is absolutely a reality and with each passing CCAR, we think investors will regain more confidence and improve multiples," the analyst said.

Multiples are a sore point for investors holding shares of many large-cap bank stocks.

JPMorgan, for example, trades for 9.3 times the consensus 2015 EPS estimate of $6.35, among analysts polled by Thomson Reuters, based on Monday's closing price of $59.20. That compares to an average forward price-to-earnings ratio of 12.7 for the 24 component stocks of the KBW Bank Index.

JPMorgan's return on average tangible common equity (ROTCE) for 2013 was a relatively low 11.92%, according to Thomson Reuters Bank Insight, reflecting the third-quarter loss the company booked as it prepared for $17.5 billion in residential mortgage-backed securities settlements in the fourth quarter. JPM's 2012 ROTCE was 14.72%, and the company's outlook calls for ROTCE to improve to a range of 15% to 16% over the next four years.

It's a pretty safe bet that JPMorgan's performance will improve this year, with lower litigation expenses.


The only large-cap bank stock trading lower than JPMorgan is Citigroup (C), which closed at $49.57 Monday, trading for 8.7 times the consensus 2015 EPS estimate of $5.73.

With Citigroup's perceived risk from emerging markets, Kotowski believes "any capital return should be viewed positively," by investors following CCAR. The analyst expects Citi to be approved to raise its quarterly dividend to 10 cents from a penny, and to be approved for up to $5.2 billion in share buybacks from the second quarter of 2013 through the first quarter of 2014.

"With JPM one is getting quality and value and potentially a 20% total return," Kotowski wrote. He expects JPMorgan to raise its quarterly dividend to 40 cents from 38 cents, and to be approved for up to $5.9 billion in share buybacks.

One of the 12 banks being added to CCAR this year is Discover Financial Services (DFS), which Kotowski sees "the biggest chance of an upside surprise on dividends." The analyst expects Discover to receive approval to raise its quarterly dividend to 25 cents from 20 cents, while also receiving approval for $1.4 billion in buybacks.

Discover is a fascinating stock, because it combines stellar earnings with a relatively low valuation. The shares closed at $59.41 Monday and traded for 10.7 times the consensus 2015 EPS estimate of $5.33. That's a very low valuation considering that the company's 2013 ROTCE was 25.26%, following a 26.82% ROTCE in 2012.

The following chart shows stock performance since the end of 2011 for JPMorgan, Citigroup and Discover, against the KBW Bank Index:

JPM Chart data by YCharts

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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