Bank Stress Tests Show No Stress

While the results are only projections, the latest round of "stress tests" shows US banks can handle adversity, says Erik Oja of S&P Capital IQ.

Large US bank capital levels should be high enough to withstand a severe recession, high unemployment, and asset price declines, according to the latest "stress tests" overseen by the Federal Reserve.

While the stress test results are only projections, they are, in our view, a good way of assessing what any bank's capital levels will be after sustaining large credit losses. Since return of capital is one reason to own bank stocks, the annual stress test is an important tool for managers and investors. We think many of the banks covered by the stress tests should be able to raise their share buyback programs, and to further increase their dividends.

This year's test forecast what would happen to a bank's capital levels in the event of a severe recession beginning in the fourth quarter of 2012. To "pass" the stress test, each bank's Tier 1 capital ratio had to remain above 5.0% after being hit with large trading and credit losses.

In this year's stress tests, the best result of the banks we cover came from regional bank BB&T (BBT), which is projected to have a 9.4% Tier 1 common ratio at the end of 2014, just below its September 30 level of 9.5%. The test projects that BBT would incur $6.0 billion of loan losses in a severe recession, with most of the losses, about $2.1 billion, coming from commercial real estate. In 2012, BBT had no share buybacks, but pays out a fairly robust quarterly dividend of $0.23 per share, which totaled $510 million, about 25% of 2012 profits of $2.03 billion. Based on how well BBT's loan portfolio held up in this year's stress tests, we expect another dividend increase within a year.

One of the big stories of the day was how well Citigroup (C) did on this year's test, showing the best improvements. For 2013, the stress test projects that Citigroup should be able to maintain a Tier 1 common ratio of 8.3% after a recession, far better than last year's stress test projection of 4.9% after a recession. Citigroup just announced that it will request from the Federal Reserve permission to buy back $1.2 billion in shares in the next five quarters. This is very conservative, in our view, as a dividend increase to $0.10 per quarter was widely expected by the consensus of analysts. For 2013, it is likely that Citigroup will maintain its quarterly dividend of just $0.01, yielding a minuscule 0.09%. We remain positive on shares of Citigroup, on our view that sales of legacy assets and cutting of expenses should be able to drive profit growth of 41%, to $10.7 billion.

The other big story of the day was JPMorgan Chase (JPM). The 2013 stress tests forecast that JPM's Tier 1 common ratio would fall to a relatively low 6.3% by the end of 2014, from a "comfortable" 10.4% at September 30, if a severe recession were to cause large trading and credit losses. The 6.3% forecast is below peers, a negative in our view, which will likely temper JPM's pending requests to the Fed for share buyback permission. We still view JPM shares as attractive at the current valuation, on its dominant global commercial lending business.

We still expect JPM to make aggressive share repurchases this year, and our forecast is for $5.0 billion. Plus, we expect dividends of $5.4 billion, on a projected $0.35 a share quarterly dividend, up from $0.30. We expect 2013 profits of $22.0 billion, up 3.4% from 2012, and we expect the $10.5 billion total of share repurchases and dividends to be 47% of profits, up from 29.5% last year.

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