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Fed’s Loan-Loss Projections May Disappoint Bank Investors

ECB Pulls Company Bond Yields Toward Record Lows
Bonds of Charlotte, North Carolina-based Bank of America Corp., were the most actively traded U.S. corporate securities by dealers with 104 trades of $1 million or more. Photographer: Patrick Fallon/Bloomberg

March 12 (Bloomberg) -- Investors may be disappointed by how U.S. banks perform in Federal Reserve stress tests as examiners expect consumer-loan losses to surpass the industry’s estimates if there’s another severe recession, analysts say.

The Fed generally has predicted firms would suffer greater losses on mortgages and credit cards than what banks estimated in capital plans submitted in January, two people with knowledge of the situation said last week, without identifying specific firms. The divergence may endanger some of the $9 billion in dividend increases and share buybacks analysts estimate may be announced after the Fed releases results this week.

“It’s going to be broadly disappointing for investors who have such high expectations,” said Todd Hagerman, an analyst with Sterne, Agee and Leach in New York. “The situation they presented was an Armageddon scenario and the banks aren’t on the same page as the Fed.”

The Fed is requiring the nation’s largest lenders to show they have credible plans for maintaining capital and continuing lending in an economic downturn. A company whose proposal isn’t approved by the Fed may be restrained in disbursing funds to shareholders or “required to take actions to improve its capital adequacy,” the central bank said in November.

Capital Payouts

The exams may be used to bolster confidence in the nation’s largest banks by demonstrating they can withstand a deeper downturn or an economic “shock” after a year in which the European sovereign-debt crisis roiled markets. Thirty-one lenders submitted capital plans that the Fed must approve before they can boost payouts and share buybacks.

The 24-company KBW Bank Index fell 0.7 percent as the broader Standard & Poor’s 500 Index rose less than 0.1 percent. The drop in financial stocks was led by Regions Financial Corp., which fell 2.9 percent, and SunTrust Banks Inc., which dropped 2.5 percent. The KBW Index has climbed 15 percent this year.

While Bank of America Corp. said it hasn’t asked to increase the dividend or repurchase stock, its performance on the test may be hurt most among the four biggest U.S. lenders if the Fed’s estimates for consumer-loan losses is greater than the industry’s, said analysts including Glenn Schorr at Nomura Securities in New York and Paul Miller at FBR Capital Markets in Arlington, Virginia.

Regions and SunTrust are among regional lenders that may have difficulty passing the stress tests, said Miller and Brian Foran, an analyst at Nomura. Both have mortgage portfolios concentrated in Florida, where home prices have fallen 49 percent since the start of the crisis.

Florida Real Estate

“The reason those guys have the most exposure is because of where they are,” Foran said. “Florida is going to have a lot of underwater real estate.”

Larry Di Rita, a spokesman for Charlotte, North Carolina-based Bank of America, Michael McCoy at Atlanta-based SunTrust and Mel Campbell of Birmingham, Alabama-based Regions, declined to comment on the Fed’s estimates.

Bankers and Fed examiners wrangled in recent weeks over the regulator’s process as the March 15 deadline for results approaches, people with knowledge of the matter said, asking not to be identified because the results aren’t public. As of last week, the Fed hadn’t given banks a ruling on their proposals or told firms how much higher its estimates are for mortgage and credit-card losses, the people said. Examiners were still fine-tuning calculations, which may change, the people said.

Investors’ Expectations

The Fed’s 25 economic variables in the tests include a 13 percent jobless rate and a 20 percent slump in home prices. When the Fed estimated losses from trading, exposure to Europe’s debt crisis, commercial lending and other non-consumer risks, the difference between its estimates and those of banks was generally low, or about 5 percent to 10 percent, according to one person.

The divergence was greater when estimating losses linked to consumers -- especially on mortgage-linked holdings and credit-card loans -- where the Fed’s projections have in some cases been almost double those of the banks, the person said.

“If the Fed fights back and disagrees and is more aggressive in their stance on cards and mortgages, it would mean banks wouldn’t be able to pay out as much,” missing investors’ expectations, said Nomura’s Schorr. Investors expect banks will pay out 50 percent to 60 percent of earnings this year, he said.

Barbara Hagenbaugh, a Fed spokeswoman, declined to comment.

“They’re very worried about the consumer,” said FBR’s Miller, a former examiner for the Federal Reserve Bank of Philadelphia. Consumers have been stretched thin in recent years and are vulnerable to economic pressures, he said. “If we go into another recession, a lot of risk officers feel this is where the damage will be done.”

Adverse Scenario

Banks may be forced to raise capital if the Fed determines they lack adequate reserves and can’t earn enough to maintain a minimum capital ratio of 5 percent under the Fed’s most adverse economic scenario, according to the people. The Fed is gauging how much capital banks have on hand to withstand a severe recession and measuring firms’ abilities to generate earnings to cover future losses, the people said.

“If you don’t make a lot of money, we don’t think the Fed’s going to give you a blessing to return capital to shareholders,” Miller said.

Bank of America Chief Executive Officer Brian T. Moynihan, 52, has said that the lender wasn’t seeking permission to boost capital payouts.

‘Double-Whammy’

“We didn’t ask for anything in the stress test,” Moynihan said at a March 8 conference in New York. “The key is to just get ourselves in the right position as we exit this year.” To help shore up the company’s capital base, Moynihan sold $33 billion in assets and announced 30,000 job cuts last year.

The bank’s retained earnings fell by $329 million last year to $60.5 billion as of Dec. 31.

“Bank of America would get the double-whammy of having a large credit-card business but also the largest mortgage exposure and also have not yet fully built back up their capital and reserves,” Schorr said. “The only saving grace is they’re not asking for a dividend or buyback.”

SunTrust and Cleveland-based KeyCorp are among banks that may find their plans to boost payouts curtailed after the stress tests, Miller said.

“Both of them have been out there saying that they’re going to pass this stress test and will return capital to shareholders,” Miller said. “We think that capital return will probably be disappointing.”

David Reavis, a spokesman for KeyCorp, didn’t respond to messages seeking comment.

To contact the reporter on this story: Dawn Kopecki in New York at dkopecki@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net

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