NEW YORK (TheStreet) -- The Federal Reserve will announce the results of its annual stress tests Thursday afternoon, and this year's results may be a whole lot more interesting than last year's, especially for Citigroup (C).
The stress tests are a two-part process. The first -- the results of which will be announced Thursday afternoon -- measures large banks' ability to remain well capitalized through a "severely adverse" economic scenario, which 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 severely adverse scenario also has international components, including recessions Europe and Japan, and slowing growth in Asia. For the U.S.-owned holding companies being tested, this part of the scenario is most important for Citigroup, which derives the majority of its revenue and earnings from outside North America.
The second part of the stress tests is the Comprehensive Capital Analysis and Review (CCAR), which applies banks' plans to deploy excess capital through dividend increases, stock buybacks and/or acquisitions to the same "severely adverse" scenario. For bank-stock investors, CCAR is the more important part of the stress-test process. The Fed will announce those results on March 26, with most of the stress-tested banks expected to announce dividend increases and/or stock buyback plans the same day.
The New Guys
The Fed this year has increased the number of banks going through the two-part process. The first part is known as the Dodd-Frank stress test, named after the massive Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law by President Obama in 2010.
The first major difference from last year is the addition of 12 more banks to this year's test group, bringing the total to 30. The new additions to the group include Discover Financial Services (DFS) and Northern Trust (NTRS) of Chicago, as well as four regional bank holding companies and six foreign-owned bank holding companies.
Here are the regional banks new to this year's Dodd-Frank stress tests:
- Comerica (CMA) of Dallas.
- Huntington Bancshares (HBAN) of Columbus, Ohio.
- M&T Bank (MTB) of Buffalo, N.Y.
- Zions Bancorporation (ZION) of Salt Lake City.
Here are the foreign-owned U.S. bank holding companies new to this year's stress tests:
- BBVA Compass Bancshares, held by Banco Bilbao Vizcaya Argentaria, SA BBVA
- BMO Financial, held by Bank of Montreal (BMO).
- HSBC North America Holdings, a subsidiary of HSBC (HSBC).
- RBS Citizens Financial Group, held by Royal Bank of Scotland (RBS).
- Santander Holdings USA, a subsidiary of Banco Santander, SA (SAN).
- UnionBanCal, which is held by Mitsubishi UFJ Financial Group.
There are two new elements in the tests this year that complicate things for the big banks. For starters, stress tests and CCAR for 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 of swaps and other derivatives.
The second new twist is the "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."
When announcing the stress test scenarios in November, the Federal Reserve said "Generally, these shocks involve large and sudden changes in asset prices, rates, and spreads, reflecting general market dislocation and heightened uncertainty." The Global Market Shock component of the stress tests will apply to the "big six" U.S. banks, including JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley.
Failing Grades and Conditional Approvals
The only bank to fail the first part of the 2013 stress tests was Ally Bank, the former GMAC, which remains majority-held by the government. But CCAR was another matter. BB&T BBT of Winston Salem, N.C., had its capital plan rejected on "qualitative" grounds. The company had a revised capital plan approved by the Federal Reserve in August, but the plan included no dividend increase and no share repurchases through the first quarter of 2014.
Two banks received conditional approval of their capital plans last year, meaning they were allowed to go ahead with dividend increases and share buybacks, but they had to submit revised capital plans to the Fed. These were JPMorgan Chase and Goldman Sachs. Both companies had their revised capital plans approved in August.
This brings us to Citigroup. In light of the massive fraud discovered last month in the bank's Banamex unit in Mexico, which led to a net pre-tax loss of $360 million and caused the company to restate its fourth-quarter financials, Citi might receive only conditional approval of its capital plan next week, according to Deutsche Bank analyst Matt O'Connor.
"The qualitative component seems at risk given recent events in its Mexican unit, but as we saw with GS/JPM a year ago C may be able to proceed (and resubmit) even with qualitative concerns," O'Connor wrote in a note to clients Thursday. He still expects Citi to be approved for share buybacks of between $6 billion and $7 billion from the second quarter of 2014 through the first quarter of 2015.
So there could be a negative headline next week for Citigroup, but the underlying news may be good.
Citigroup remains a very interesting play for investors, because the stock is so cheap relative to other large-cap U.S. banks. The shares closed at $48.94 Wednesday and traded for 0.9 times tangible book value, according to Thomson Reuters Bank Insight, and for 8.6 times the consensus 2015 earnings estimate of $5.72. The consensus 2014 EPS estimate is $4.84.
Please see the following articles for more on Citigroup's stress-test prospects and what to expect when the company announces its first-quarter results on April 14:
Citi's shares were up 0.8% in early trading Thursday, to $49.29.
This chart shows the performance of Citi's stock against the KBW Bank Index (I:BKX) and the S&P 500
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