Fed Tests Show 17 of 18 Banks Weathering Severe Slump

The Federal Reserve said 17 of the 18 largest U.S. banks could withstand a deep recession and maintain capital above a regulatory minimum, a sign of how higher standards and supervisory prodding are strengthening the financial system.

Only Ally Financial Inc. (ALLY), the auto lender majority-owned by U.S. taxpayers, fell below a 5 percent Tier 1 common ratio, a regulatory minimum and measure of financial strength, according to data released today by the central bank in Washington. Morgan Stanley (MS) showed a minimum Tier 1 common ratio of 5.7 percent in the test and Goldman Sachs Group Inc. (GS) a ratio of 5.8 percent.

“Even under punitive assumptions you have capital that is above the minimum thresholds of the Fed” for almost all banks, “and that is a good sign for the health of the financial system,” said R. Scott Siefers, a managing director at Sandler O’Neill & Partners in New York. “Even though banks are paying out more of their earnings than a couple of years ago, there has still been an increase in retained earnings,” which bolsters capital.

Since the 2008-2009 financial crisis, U.S. regulators have tried to minimize the odds of another taxpayer rescue, compelling banks to retain some earnings and reinforce their buffers against possible losses. New international and domestic banking rules are also guiding banks toward stronger capitalization.

Housing Rebound

With the economy in the fourth year of expansion, banks are also benefiting from a housing-market rebound, falling mortgage delinquencies and record-low short-term interest rates that boost earnings.

Projected losses for the 18 banks under a scenario of deep recession and peak unemployment of 12.1 percent would total $462 billion over nine quarters, the Fed said. The aggregate Tier 1 common capital ratio would fall from an actual 11.1 percent in the third quarter of 2012 to 7.7 percent in the fourth quarter of 2014. The firms represent more than 70 percent of the assets in the U.S. banking system.

The Tier 1 common ratio measures a bank’s core equity, made up of common shares and retained earnings, divided by its total assets adjusted for risk using global banking guidelines.

The ratio grew especially important during the financial crisis as investors applied extreme mark-downs on bank portfolios to see whether firms had enough core equity to absorb additional losses or the potential for balance sheet growth.

‘Fundamentally Flawed’

Ally disputed the Fed’s results, calling the analysis “inconsistent with historical experience” and “fundamentally flawed.”

Citigroup Inc. (C), the only U.S. bank among the six biggest to have its capital plan rejected last year, said today that it asked the Fed for permission to repurchase $1.2 billion of shares without seeking a dividend increase.

The bank’s submission “underlines management’s commitment to build and sustain robust levels of capital,” Citigroup said in a presentation on its website. “At the core of Citi’s capital assessment framework is a focus on safety, soundness, credibility and confidence.”

Spokesmen for other banks declined to comment on their firms’ views of the Fed’s estimates or didn’t respond to requests for comment.

Dodd-Frank

The Fed published its first stress test of large U.S. banks in 2009, and changed the program into a more detailed capital plan review. Today’s results were conducted under a format mandated by the 2010 Dodd-Frank Act, one of the most sweeping reforms of financial regulation since the 1930s.

The results are a prelude to the Fed’s capital plan review of the same banks scheduled for release on March 14. That review measures how dividend or share-buyback plans affect capital, and is a decision point for banks to increase such outlays if their ratios are sufficient.

Today’s results don’t forecast next week’s, because the Dodd-Frank test doesn’t include forward-looking management decisions, a Fed official said on a conference call with reporters.

“What the stress test disclosure does is give markets much more information than they have had about the possibility of banks dealing with situations on a comparative basis,” said Hal Scott, a Harvard Law School professor and director of the Committee on Capital Markets Regulation, a research group of academics and industry leaders. Bloomberg LP Chief Executive Officer Daniel Doctoroff is a member of the committee.

Financial Calamity

The Fed said in a release that the “projections should not be interpreted as expected or likely outcomes for these firms, but rather as possible results under hypothetical” conditions. The Fed official said the severely adverse scenario represents a financial calamity of greater magnitude than any two-year period in the last 100 years except for the Great Depression.

In the scenario, the 18 lenders would lose $316.6 billion on souring debts, led by Bank of America Corp. (BAC) The Charlotte, North Carolina-based firm would lose $57.5 billion, followed by Citigroup, with $54.6 billion. JPMorgan Chase & Co. (JPM) and Wells Fargo & Co. (WFC) both would lose almost $54 billion.

As a share of a company’s loans, Capital One Financial Corp. (COF)’s portfolio performed worst, with losses amounting to 13.2 percent of its holdings, according to the Fed. That compared with 6.9 percent at Bank of America and 7.7 percent at New York-based JPMorgan, the biggest U.S. lender.

Home Loans

Home loans were the largest source of bad debt in the Fed’s tests with $60.1 billion in projected losses on first mortgages and $37.2 billion on junior lien and home-equity loans. Bank of America would face $24.7 billion in losses, as San Francisco-based Wells Fargo incurs $23.7 billion, the Fed estimated.

The next-largest source of bad debt was credit cards, which the Fed estimated would cost banks $87.1 billion. New York-based Citigroup, the world’s biggest credit-card lender, led loss estimates with $23.3 billion. McLean, Virginia-based Capital One’s card portfolio performed worst in the test, with losses amounting to 22.2 percent.

The biggest sources of losses are those “on the accrual loan portfolios and trading and counterparty losses from the global market shock,” the Fed said in its release. “Together, these two account for nearly 90 percent of the projected losses” for the 18 banks under the severely adverse scenario.

Doubled Capital

Capital One estimated a 9.6 percent loss rate for its loans, including an 18 percent rate on credit cards.

“Our stress-test methodology considers a broad range of potential stresses to our balance sheet and capital,” the firm said in a statement on its website. The analysis was “informed by a number of factors, including our experience in the 2008 financial crisis and subsequent recession.”

U.S. banks have grown stronger since the crisis. The Fed said in November the largest banking groups had nearly doubled their Tier 1 common capital to $803 billion in the second quarter of last year from $420 billion in the first quarter of 2009.

The KBW Bank Index, which tracks shares of 24 large U.S. banks such as JPMorgan, State Street Corp. (STT) and Capital One, has risen 9.7 percent this year, compared with the 8.3 percent gain of the Standard & Poor’s 500 Index.

The Fed for the test gave banks 26 variables -- ranging from interest rates to stock and home-price indexes -- and showed how they would change over time. The Fed also gave banks an adverse scenario with rising interest rates and a baseline scenario, and didn’t disclose the results for these.

Early Look

Under the most adverse scenario, U.S. gross domestic product doesn’t grow or contracts for six consecutive quarters. Unemployment peaks at 12.1 percent, and real disposable income falls for five consecutive quarters. Stock prices tumble 52 percent, and house prices fall 21 percent.

Next week’s tests, known as the Comprehensive Capital Analysis and Review, for the first time provides banks with an early look at how they performed under the analysis, giving them a chance to revise their capital plans. If their capital can withstand those conditions without pushing ratios below regulatory levels, and if their analysis is rigorous enough, the Fed signs off.

“The point is to bar capital distributions from under-capitalized or risk-prone bank holding companies, which happened a lot, with full Federal Reserve Board approval, even as the crisis was clearly revving up,” said Karen Shaw Petrou, co-founder of Federal Financial Analytics, a Washington firm that specializes in financial regulation analysis.

The 19 largest banks in 2007 paid out more than $43 billion in dividends as housing prices continued their fall, and an additional $39 billion in 2008 as the crisis began to accelerate, Patrick Parkinson, the former head of the Fed Board’s supervision and regulation division said in 2011. He is now a managing director at Promontory Financial Group LLC.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Joshua Zumbrun in Washington at jzumbrun@bloomberg.net.

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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