The Fed's Stress Test On Banks

By Greg McFarlane | March 16, 2012 AAA
The Fed's Stress Test On Banks


Unemployment is officially at 8.3%, the Dow sits around 13200 (as of writing), the average home sells for $214,000, and about 80% of Americans cite the economy as their biggest concern.

Now, imagine if unemployment rose to 13% (where it hasn't been since the Depression), the Dow fell to 6600 (where it was three years ago) and the average home price fell to $169,000 (which is to say, its 1996 level). Fortunately, you don't have to, because the Federal Reserve already did, and concluded that it needs to tighten the reins on lending institutions even more.

SEE: When The Federal Reserve Intervenes (And Why)

Stress Testing
On March 13, the Fed announced the results of its annual "stress tests." Basically, Chairman Ben Bernanke has the CEOs of JP Morgan Chase and Bank of America hooked up to an EKG and makes them run on a treadmill until they collapse in a heap and finally agree to make good on the tens of billions of taxpayer dollars they received in 2008's Troubled Asset Relief Program.

Unfortunately, that's not quite how the Fed's stress tests work. Instead, the Fed constructs the above doomsday scenario, assumes it'll last for two years and three months and then guesses how much money the 19 largest banks in America would lose. After this year's battery of tests, the Fed determined that four of those banks (Citigroup, SunTrust, Ally and MetLife) would lose at levels that would put the entire financial system at risk.*

These test results don't necessarily mean that those banks are in danger, or anything approaching danger. The results just state that if the asteroid were to break out of its orbit and hit the Earth, so to speak, these are the banks that would be closest to the point of impact.

Dividends and Share Buybacks
So how does the Fed guess what said banks would do under such a hypothesis of its own construction? Among other items, it predicts how the banks would handle dividends and share buybacks.

Sufficiently successful companies pay dividends to their stockholders, if enough of those stockholders demand it. (They don't always demand it, or at least they don't always have the votes on the board of directors to do so. Just ask the Apple shareholders who are still waiting for their inaugural dividend, with the company now in its fourth decade of public trading.) Some companies make it a point of raising those dividends, however gradually, every year. More money in the shareholders' pockets means less operating cash on hand. In the case of a bank, the Fed thinks that could precede a panic, even though it'd be self-defeating for a bank's managers to hand over enough cash to render the bank untenable.

Share buybacks are a similar thing, except that the company buying its stock back receives something - its own stock - in exchange for cash it would otherwise just give away. In general, a company that buys back much of its own stock and/or pays large dividends is, by definition, healthy. After all, no company would want to buy worthless stock. Nor would any want to pay dividends when it needs that cash to operate.

Falling Behind
It's hard to ignore that the most prominent name on the list of failures is Citi, a bank that received tens of billions of taxpayer dollars and enough loan guarantees to put entire major Western economies to shame. The Fed became Citi's largest de facto creditor, and is now holding up the bank (to coin a phrase) as an example of an insufficiently capitalized lender.

As for Ally, if you're only a casual observer of this sort of thing and are wondering why "Ally" has become a familiar name only in recent years, it's because it was renamed. Ally was known for decades as General Motors Acceptance Corporation. It was, and is, the financing arm of what used to be the largest company on Earth, and in the late 2000s would have ceased to exist if not for the largesse of the U.S. Treasury.

Today, Ally itself is owned by, well, mostly you, whether you want to own it or not. Nearly three-quarters of its stock is held by the U.S. Treasury, most of the rest by General Motors' and Chrysler's parent companies and other investors. Those parent companies still operate thanks to the federal government that used taxpayer money to bail out said car manufacturers in the first place. So, the Fed is essentially determining the robustness of subsidiaries under its own auspices, which it then finds wanting.

Improved Prices and Dividends
This year marked the first time that the Fed had released its test results. The publication of those results helped the stocks of the banks that passed the tests. JP Morgan Chase announced a plan to repurchase $15 billion of its stock, and to raise its dividend from $1 a year (paid quarterly) to $1.20. The stock itself rose nearly 8% between the day before the Fed released the stress test results and the day after. Bank of America stock rose by a similar ratio, as did most of the others.

In a wonderful display of earnestness, the Fed added that all 19 banks are in better shape than they were in the midst of the 2008 financial crisis. Yeah, and London was in better shape the day World War II ended than it was during the Battle of Britain.

The Bottom Line
It's hard to see what this fire drill did, other than have an indirect, temporary effect on the stock prices of the banks in question. If you're a wise investor, then continue to make your decisions based on financial statements, rather than press releases. If you believe that the federal government has enough of a stranglehold on the banking industry as it is, then consider putting your money in a community bank or a credit union. Lastly, if you believe that the Fed wouldn't step in to save an undercapitalized Ally or Citi with your tax dollars, yet again, then you may want to consider investing in some magic beans.

*The 15 other banks are American Express, Bank of America, Bank of New York Mellon, BB&T, CapitalOne, Fifth Third, Goldman Sachs, JP Morgan Chase, Keycorp, Morgan Stanley, PNC, Regions, State Street, U.S. Bancorp and Wells Fargo. If you hate staying awake, you can plow through the Fed's testing methodology here.

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