U.S. Banks’ $75 Billion Payout at Stake in Stress Tests

The biggest U.S. banks are about to learn whether they can pay out more than $75 billion in excess capital to investors as the Federal Reserve completes stress tests of their ability to survive new economic calamities.

Wells Fargo & Co. and JPMorgan Chase & Co. would lead a 69 percent increase in dividends and stock buybacks over the next 12 months after the central bank releases results of its annual tests on March 20 and March 26, according to analysts’ estimates compiled by Bloomberg. That’s assuming the companies pass, which some of the analysts say is less than assured.

“We know the banks have enough capital, that’s not the question,” Todd Hagerman, an analyst at Sterne Agee & Leach Inc. in New York, said in an interview. “It’s more about whether there is something in the capital-planning process that the Federal Reserve might object to.”

Investors and analysts including Hagerman are confident the six biggest firms will pass because of the capital cushions and experience they’ve amassed since stress tests began in 2009. There’s more concern that some of the 12 smaller banks taking part for the first time might not pass and speculation the Fed could reject one or more firms of any size for flawed planning.

“That’s the biggest risk,” said R. Scott Siefers, an analyst at Sandler O’Neill & Partners LP. “The regulators may simply choose to fail one or two guys qualitatively every year.”

Sudden Demise

In addition to the largest commercial lenders, the tests cover the biggest regional banks, securities firms including Goldman Sachs Group Inc. and Morgan Stanley, credit-card issuers such as American Express Co. and custodial banks State Street Corp. and Bank of New York Mellon Corp. The tests of 30 companies are designed to prevent a repeat of the $700 billion bailout program during the 2008 crisis, and the Fed changes the dire economic scenarios that go into the decision each year.

This time, firms must show they can ride out a plunge in the value of high-risk business loans and another housing bust. Eight of the biggest banks also must demonstrate that they can handle the sudden demise of their trading partner with the potential for the greatest losses.

Bankers will have to describe in the “adverse” scenario what would happen to the value of their existing portfolio of riskier commercial loans should yields rise as high as 9.2 percent in the third quarter of 2014. In the Fed’s “severely adverse” scenario, the unemployment rate peaks at 11.25 percent, stocks fall almost 50 percent and U.S. housing prices slide 25 percent, while the euro area sinks into recession.

Operational Risk

Last year, the Fed ordered JPMorgan and Goldman Sachs, the largest and fifth-biggest U.S. banks, to submit new capital plans to address weaknesses. The central bank rejected submissions from Detroit-based Ally Financial Inc. and BB&T Corp. in Winston-Salem, North Carolina. New York-based American Express had to revise its plan to win approval.

“They need to understand there’s a huge qualitative element to this,” said John Corston, a former regulator at the Federal Deposit Insurance Corp. who now works at Deloitte & Touche LLP in Washington. “When you’re looking at areas like legal settlements or issues in the mortgage area, included in the process is an estimate that looks at operational risk.”

The biggest increase in payouts may come from Citigroup Inc., ranked third by assets and run by Chief Executive Officer Michael Corbat, 53. The New York-based firm could return $6.6 billion in the year beginning April 1, compared with $121 million in the previous 12 months, according to an average of four analysts’ estimates compiled by Bloomberg. The predictions range from as much as $8.2 billion to as little as $4.7 billion.

Citigroup Challenge

Citigroup’s request may be complicated by a $400 million fraud the bank reported last month after it found falsified documents tied to loans made by its Mexican unit to an oil-services firm, according to Chris Kotowski, an Oppenheimer & Co. analyst in New York. Management can’t say whether the episode would affect the test’s outcome, John McDonald, a Sanford C. Bernstein & Co. analyst, wrote last week after meeting with Chief Financial Officer John Gerspach.

Kotowski said the bank’s “modest” payout request probably will be granted.

“I could imagine the Fed adding some language or conditionality to it -- that they need to demonstrate that this was an isolated incident and that they have examined and tightened their procedures,” Kotowski said in an e-mail. Banking frauds are almost inevitable, and Citigroup must show that it won’t be “allowed to mushroom in size,” he said.

‘Very Profitable’

The six largest U.S. banks may return $47.8 billion starting in April, the estimates show. That compares with $23.6 billion for the prior year, according to Stifel Financial Corp.’s KBW unit. The firms gave back $66.4 billion in the 2007 calendar year, data compiled by Bloomberg show.

“The dividends and buybacks -- the sheer size of them -- suggest there is plenty of profit to play with,” David Ellison, a Boston-based mutual-fund manager specializing in financial stocks at Hennessy Advisors Inc., said in a phone interview. “It shows that if a bank is run appropriately, it’s very profitable.”

Wells Fargo, the nation’s largest home lender and the most profitable U.S. bank in 2013, will return as much as $14.7 billion or as little as $13.5 billion, estimates show. That compares with about $7.8 billion the San Francisco-based firm will have paid in the 12 months ended March 2014.

The bank’s annual dividend will climb to $1.28 a share from $1.20, according to KBW. That would boost the payout ratio -- dividends and buybacks as a percentage of profit -- to 62 percent from 37 percent, KBW said.

JPMorgan Payout

JPMorgan may give back as much as $15.5 billion and as little as $10.6 billion, the estimates show. That compares with about $7.5 billion returned the prior year by the New York-based firm, which is led by CEO Jamie Dimon, 58. The dividend may climb to $1.64 a share from $1.52, raising the total payout ratio to 56 percent from 47 percent, according to KBW.

Regulators will have to decide whether disputes with JPMorgan over mortgage-bond sales, money-laundering prevention and management controls affect the outcome of the tests. Marianne Lake, 44, the company’s CFO, told investors last month the bank expects to have significant excess capital that can help fund “a healthy dividend payout with the potential to increase over time” as well as buybacks. Dimon said JPMorgan might “add a penny or two every quarter, or something.”

Benefiting Moynihan

Bank of America Corp.’s payout could range from $8.7 billion to as little as $5.5 billion, according to the estimates. The Charlotte, North Carolina-based firm returned about $4.4 billion in the 12 months ending March 2014.

Any increase would benefit Brian T. Moynihan, 54, who has made restoring payouts a priority since 2010, when he became CEO at the nation’s second-largest bank. Moynihan came under fire in 2011 after fanning investor expectations for a “modest” dividend increase, only to have the Fed reject his request. He didn’t ask for one the following year and won approval for a $5 billion buyback in 2013.

Morgan Stanley may pay out $2.1 billion, according to an average of analysts’ estimates. In the prior year, the New York-based firm’s stock issuances were greater than its buybacks and dividends. Goldman Sachs, also based in New York, will return $6 billion over the next 12 months, compared with $3.9 billion in the period ending this month, the estimates show.

Spokesmen for the six banks declined to comment.

New Participants

Among the 12 new participants, six are U.S. units of foreign lenders, including HSBC North America Holdings Inc. and BBVA Compass Bancshares Inc.

Zions Bancorporation, the Salt Lake City-based lender participating for the first time, notified the Fed it will resubmit its plan after determining that losses triggered by the Volcker Rule will be less than anticipated. The rule, named after former Fed Chairman Paul Volcker and included the 2010 Dodd-Frank Act, bans some riskier holdings, and Zions said in December it would have to sell some of them at prices so low that annual profit could be wiped out.

New participants also include M&T Bank Corp., the Buffalo, New York-based lender whose takeover of Hudson City Bancorp Inc. has been stalled by regulators since August 2012 while they scrutinize M&T’s money-laundering controls.

“On the new entrants, the Fed may show a bit of leniency,” Chris Mutascio, a KBW analyst in Baltimore, said in a phone interview. “The new entrants doing the new submittals are going to be a bit more cautious in what they ask for.”

Dividends, Buybacks

The average potential payouts were compiled from estimates provided by analysts at Goldman Sachs, Credit Suisse Group AG, Sandler O’Neill and KBW covering the 23 publicly traded U.S.- based banks in this year’s test. The six U.S. units of foreign lenders and Ally were not included, and Goldman Sachs excludes itself from the estimates. The payouts include dividends and buybacks beginning in April and running through March 2015. KBW analysts provided the year-earlier numbers.

Investors use dividends and buybacks to gauge management’s level of optimism, and look forward to the boost they give to share prices. The 24-company KBW Bank Index returned 21 percent over the past 12 months compared with the 18 percent return of the Standard & Poor’s 500 Index.

Combined annual profit at the six largest banks rose 28 percent to $75.9 billion in 2013 from $59.5 billion the prior year, according to data compiled by Bloomberg. The firms had an average Tier 1 common equity ratio as measured under Basel 3 rules of about 10 percent, the data show. Regulators use the ratio, which compares a firm’s equity capital to its risk-weighted assets, to measure a bank’s cushion against losses.

‘Little Tougher’

The Fed will release the results in two stages. On March 20, it will show how banks performed on a stress test mandated by Dodd-Frank. Six days later, regulators will disclose results for the Comprehensive Capital Analysis and Review, which focuses on capital planning and assesses how increases in the dividend or share buybacks would affect them.

“The Fed seems to be a little tougher each time,” Moshe Orenbuch, a Credit Suisse analyst in New York, said in a telephone interview.

The possibility of a rejection is leading some institutional investors to steer clear of bank stocks or hold a smaller position than they otherwise would, said David Hilder, an analyst at Drexel Hamilton LLC in New York.

“There is a concern that regulators will keep moving the goal posts,” Hilder said. Investors “are concerned that they don’t know when or how regulators will stop making life difficult for the banks.”

Payout Threshold

As banks build capital and start to show ratios higher than what regulators demand, some lenders could ask to pay out more than 100 percent of earnings, using a combination of current profit and excess capital, according to the analysts surveyed. Some are already close to that threshold, with Boston-based State Street projected to have the highest payout ratio this year at 91 percent, according to KBW.

The median payout ratio among all 23 publicly traded banks will increase to 68 percent of earnings from 47 percent the prior year, according to KBW.

Higher ratios don’t guarantee the stock will improve, according to a report last week from Matthew Keating, an analyst at Barclays Plc who covers smaller lenders. Keating cited regional banks with the highest payout ratios -- People’s United Financial Inc., First Financial Bancorp and Capital Bank Financial Corp. -- whose shares nevertheless trailed their peers in 2013. The best performers such as SVB Financial Group had some of the lowest payouts, he said. None of those lenders is among the banks undergoing stress tests.

The Fed probably won’t let any firm cross the 100 percent mark this year, Orenbuch said. Next year could be different, according to Gerard Cassidy, an analyst at RBC Capital Markets in Portland, Maine.

“The Fed has stated, beginning in 2015, there will be no payout ratio limitations for banks that are well-capitalized,” Cassidy wrote in a Feb. 20 note. “We anticipate selected banks will push for combined payout ratios greater than 100 percent.”

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