Bank Stress Test Results

Better late than never... The Fed, OCC and FDIC finally produced their highly anticipated Supervisory Capital Assessment Program (SCAP), which is known among friends as the "Bank Stress Test." As expected, none of the 19 American banks in question is flirting with near-term insolvency, but about 50% of the banks analyzed would need capital should the economy deteriorate toward the Fed's worst case scenario, according to the analysts.

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The Fed's aforementioned worst case scenario happens to coincide with the average economist's forecast. In other words, it's not that bad. That helped the market get past phase one of this ordeal, which incorporated the release of the stress test criteria some time back. To get passed phase two, the market needed to know whether the financial sector was in good enough condition to weather the current rainfall and the worst case hurricane the Fed could imagine.

Bank Stress Test Results

And the results are in...

Federal Reserve Statement on the Bank Stress Test

Joint Statement:
"The exercise--conducted by the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation--was conducted so that supervisors could determine the capital buffers sufficient for the 19 BHCs to withstand losses and sustain lending--even if the economic downturn is more severe than is currently anticipated. In a detailed summary of the results of the Supervisory Capital Assessment Program (SCAP), the supervisors identified the potential losses, resources available to absorb losses, and resulting capital buffer needed for the 19 participating BHCs."

Bernanke's Statement on the Bank Stress Test

We are not going to republish the Chairman's brief statement word for word, but highlight some of the interesting notes he offered. The Chairman reinforced the reasoning and importance of this stress test endeavor, one that has been highly criticized by the popular press and economic protagonists. The stress test has been labeled a publicity stunt, a marketing ploy gone awry and even a sham.

We think Bernanke set things straight with this statement, "These institutions play a vital role in our economy, holding among them two-thirds of the assets and more than one-half of the loans in the U.S. banking system." It's clearly critical that we know just where they (read we) stand, should the economy face an unforeseen curve ball on the way to recovery. And in a society like ours, built on transparency and freedom, was there really any other way to do it than publicly?

The Chairman stirred up a few more thoughts in us with these statements, "The results released today should provide considerable comfort to investors and the public. The examiners found that nearly all the banks that were evaluated have enough Tier 1 capital to absorb the higher losses envisioned under the hypothetical adverse scenario. Roughly half the firms, though, need to enhance their capital structure to put greater emphasis on common equity, which provides institutions the best protection during periods of stress. Many of the institutions have already taken actions to bolster their capital buffers and are well-positioned to raise capital from private sources over the next six months. However, our government, through the Treasury Department, stands ready to provide whatever additional capital may be necessary to ensure that our banking system is able to navigate a challenging economic downturn."

As reassuring as his first line was, we could not help but wonder why this confident confidante of ours was so concerned at this point in the economic cycle to bring this kind of attention to the banks; especially when things appeared to be on the road to recovery. This is precisely the question that froze investors in place over the past few weeks of range-bound trading. Just what frightens Messenger Bernanke anyway? What keeps him up at night, and who may have put this idea into his head and why? Could the Chinese be serious about diversifying away from the dollar? Is Israel going to bomb Iran after all? Is Pakistan perilously close to Islamic fundamentalist rule? Has Russia lost its marbles? Is swine flu something more than the mild illness it appears to be? Is pure evil loose on the world!?!!!! What has the astute professor so worried that he would bring this unwanted attention to a sector that so needs to recover... Or, was this idea born at time when Bernanke thought it necessary to reassure the market, and maybe even the lenders themselves.

Stress Test Results

Without further ado, let's have a look see. The test broke the nineteen into two groups: those who would not need more capital; and those who have six months to raise it or else take on government ownership interest.

The Good Banks

The winners included banks that had already been scoring well, including the likes of JP Morgan Chase (NYSE: JPM) and Goldman Sachs (NYSE: GS). The rest of the top of the class included American Express (NYSE: AXP), BB&T (NYSE: BBT), Bank of New York Mellon (NYSE: BK), Capital One (NYSE: COF), MetLife (NYSE: MET), State Street (NYSE: STT) and US Bancorp (NYSE: USB). These banks can go about there business and watch their stocks soar on the good news. Meanwhile...

The Bad Banks

The banks that have to stay after class to do some more homework include Bank of America (NYSE: BAC), Citigroup (NYSE: C), Fifth Third (Nasdaq: FITB), GMAC (NYSE: GJM), KeyCorp (NYSE: KEY), Morgan Stanley (NYSE: MS), PNC Financial (NYSE: PNC), Regions Financial (NYSE: RF), SunTrust (NYSE: STI) and Wells Fargo (NYSE: WFC). These sorry souls must now raise capital to the Fed's outlined threshold within six months time, or likely face the forcing of government capital down their throats. Welcome to our lovely new democracy.

You would think that the biggest problem for the bad banks now would be raising the suggested equity capital at a decent price, given the "damaged goods" label smacked on them by the federal government. In an intriguing turn of events, many of the short-handed banks can satisfy the government's requirements by converting government debt into equity. So did our government just force their own increased equity interest in the banking system in discreet fashion? Interesting thought isn't it... Citigroup, for one, is already doing this, and maybe this is the only option for a few of the stragglers.

One Tough After Thought

The government's test results exposed its expectations for dramatic bank loan loss rates as the downturn progresses. Specifically, the government gurus forecast total loan loss rates may reach 9.1%, which is more than was seen in the Great Depression. This raises concern for the not too big to fail group of smaller regional banks that were not stress tested this spring. Also, it seems to point a risky finger at KeyCorp and GMAC, if we had to single out a couple names where hefty loan loss expectations compare against lesser capital raising capability... and that's not to mention KeyCorp's big credit card exposure. Needless to say, this test probably put KeyCorp's existence at expedited risk. The stock opened gap lower, but investors were enthused that it only had to raise $1.8 billion by the Fed's standard, and so it closed slightly higher on the day. GJM shares dropped 3%.

The big winner on the day was Fifth Third (Nasdaq: FITB), which soared 59% on a sort of reverse "buy the rumor, sell the news" trade. Capital One (NYSE: COF), like the Kentucky Derby underdog, saw a similar benefit, rising 18%.

A total of $75 billion dollars will be needed by the bad banks, but that was less than expected, and so the market saw a relief rally of sorts as a result. The Dow ^DJI, S&P 500 ^GSPC and Nasdaq ^IXIC all moved higher by 1% to 2.5% on the day. Even Bank of America (NYSE: BAC), which was commanded to raise $34 billion, more than any other bank, managed to climb 5% on the day. BAC is the largest bank in the country by far, and so the proportional capital need was not so off-balance.

Banks got into the money raising game almost immediately. It seems they did not want to give the market too much time to discount their inadequacies. Wells Fargo raised $8.6 billion in a shotgun equity offering only announced on May 7. Morgan Stanley will seek to raise $8 billion or so, more than enough to meet its $1.8 billion peg.

All in all, the government managed to do what it wanted to do today. There has been an ongoing effort to sort of clear the air, or provide clarity to the economic situation. They have forecast economic stabilization and growth, and the numbers have started to fall in line, making that believable. The Administration has accentuated the positive, and drawn a line in the sand with regard to government payouts for autos and others. Visibility is generally improving, and with visibility comes progress.


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