Bank of America 'Struggles' in Stress Test

Updated from 8:42 a.m. ET with morning market action and comment from Credit Suisse analyst Moshe Orenbuch.

NEW YORK (TheStreet) -- Now that the first round of the Federal Reserve's annual stress-test process is complete, the biggest loser is Zions Bancorporation (ZION) of Salt Lake City, but Bank of America's (BAC) results are also of concern to investors.

In the first round of stress tests -- known as the Dodd-Frank Act Stress Tests, or DFAST -- 30 large banks had to show they could remain well-capitalized, with Tier 1 common equity ratios of at least 5.0%, through a nine-quarter "severely adverse" economic scenario. The list of banks being tested grew from 18 last year, with Zions among several regional banks being added to the tests.

Zions was the only bank to fail DFAST, with a minimum Tier 1 common equity ratio of just 3.5%. Bank of America passed, but had the third weakest minimum Tier 1 common equity ratio through the nine-quarter scenario, at 6.0%.

The second-weakest was M&T Bank (MTB) of Buffalo, N.Y., with a minimum Tier 1 common equity ratio of 5.9%. But M&T is in the midst of getting its Bank Secrecy Act and anti-money laundering compliance house in order, as it prepares to complete its long-delayed acquisition of Hudson City Bancorp HCBK of Paramus, N.J. M&T is very unlikely to request any increase in dividends or to request approval for any share buybacks in the second round of the stress tests.

Shares of Bank of America were down 1.3% in morning trading to $17.69, while Zions was down 2.7% to $32.11.

The second round of tests is the Comprehensive Capital Analysis and Review, or CCAR, which incorporates banks' plans to deploy excess capital through dividend increases, share buybacks and/or acquisitions. Those results will be announced on March. 26, with most of the tested banks making their own capital return announcements the same day.

This year's "severely adverse" 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 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.

In addition to expanding the list of banks being tested, the Fed introduced new elements for the largest banks that are considered global systemically important financial institutions (G-SIFIs). The tests for these banks factor in the instant default of a bank's largest counterparty for trading of swaps and other derivatives.

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

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." This element applies to the "big six" U.S. banks, including JPMorgan, Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley.

In its press release announcing the stress-test results, the Federal Reserve's tone was largely positive. The regulator said that even under its "severely adverse" economic scenario, under which the 30 tested banks would lose a combined $366 billion over the nine-quarter period, the group's minimum Tier 1 common ratio would be 7.6%, "significantly higher than the 30 firms' actual tier 1 common ratio of 5.5 percent measured in the beginning of 2009."

Bank of America

In a note to clients on Friday, Atlantic Equities analyst Richard Staite wrote, "Not surprisingly the retail banks fared best in the Fed stress test with PNC having the largest percentage cushion over the minimum while WFC had the largest dollar value cushion at $37bn."

"Universal and investment banks continue to fare worse, particularly BAC which saw its ratio fall to only 6% implying only a $13bn surplus over the minimum."

Nevertheless, Staite belies the $13 billion surplus will be enough for Bank of America to have its capital plan approved next week, including an estimated $5 billion in share buybacks and $2.5 billion in dividends paid from the second quarter of 2014 through the first quarter of 2015.

"We will be focused on BAC, which had a worse stress test result relative to the prior year. Therefore, Street expectations for a materially higher dividend ($0.20 annually versus $0.04 annually) could be at risk," wrote FBR analyst Paul Miller in a client note on Friday.

Bank of America could receive "conditional approval" of its capital plan, meaning the Fed would approve the payouts, but also require a revised plan from the company on how it would preserve capital through the "severely adverse" scenario. This is what happened last year with JPMorgan Chase and Goldman. Both of those companies were allowed to go ahead with capital deployment, while having their revised plans approved in August.

"Both BAC and C came in weaker than our forecasts with the differential relative to our estimates partly due to the DTA position lack of tax benefit of losses. We think there is some possibility that BAC may have to resubmit its capital return request given its only 100bp buffer relative to the minimum of 5% (and the relatively large differential between the firm-calculated minimum of 8.6% and the Fed at
6.0%)," wrote Credit Suisse analyst Moshe Orenbuch in a note to clients Friday.

Citigroup passed the first round of stress tests with a minimum Tier 1 common equity ratio of 7.0%. But Citi is another bank that may possibly receive conditional approval of its capital plan next week, because of its much higher level of international exposure than the other members of the "big six" banking club.

Zions

In a Wall Street Journal article, a Zions Bancorporation spokesperson was quoted as saying its failure in the first round of stress tests didn't "reflect a reduction in the risk profile of the company... It's a number that will reflect the fact that at the date of submission we had more risk on the balance sheet. Today we have less risk on the balance sheet."

One way Zions has reduced its risk since September has been the sale of collateralized debt obligations with a par value of $631 million and amortized cost of $282 million in January, which resulted in pre-tax gains of $65 million. Some of those sales were made in part to comply with regulators' final set of rules implementing the Volcker Rule's ban on certain types of CDOs.

Zions had already said on Feb. 12, when announcing the CDO sales, that it would resubmit its capital plan to the Fed, since the original plan was based on its Sept. 30 financial reports. The company in a press release Thursday night again said it would submit a revised capital plan, and that "the resubmission will contain additional actions that will further reduce risk and/or increase its common equity capital sufficient to cause Zions' capital ratios to meet or exceed the minimum capital ratios under the Federal Reserve's hypothetical severely adverse economic stress scenario."

Discover Jumps the Gun

Discover Financial Services (DFS) is among the 12 banks added to this year's stress tests. The company passed with flying colors, with a minimum Tier 1 common equity ratio of 13.1%, which put it in a tier with Bank of New York Mellon (BK) for second place, only exceeded by State Street (STT) of Boston, with a minimum Tier 1 common equity ratio of 13.3% through the "severely adverse" scenario.

But Discover is the only company to disclose how much capital deployment it had requested from the Federal Reserve. Discover plans to increase its quarterly dividend to 24 cents from 20 cents, and to repurchase up to $1.6 billion in common shares from the second quarter of 2014 through the first quarter of 2015.

Investors will find out whether or not Discover can follow through with that plan when the Federal Reserve announces the CCAR results next Wednesday at 4 p.m. ET.

Discover's shares were down 1.1% in morning trading to $58.09.

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.

More from Stocks

Dow Rebounds From Thursday's Sharp Decline, P&G Jumps

Dow Rebounds From Thursday's Sharp Decline, P&G Jumps

PayPal Soars on Earnings Beat, but Can the Strength Be Sustained?

PayPal Soars on Earnings Beat, but Can the Strength Be Sustained?

PayPal Surges as Results, New Partnerships Boost Outlook

PayPal Surges as Results, New Partnerships Boost Outlook

Home Depot Customers Bought Before the Storms, Investors Might Want to Sell

Home Depot Customers Bought Before the Storms, Investors Might Want to Sell

The Fed Pulls a Miley Cyrus and Comes In Like a Wrecking Ball

The Fed Pulls a Miley Cyrus and Comes In Like a Wrecking Ball