Should We Find Comfort in the Fed’s Stress Tests Results?

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The Federal Reserve announced late Tuesday the details of its latest “stress test” of major American financial institutions, and the markets greeted the results with qualified optimism. Nineteen banks submitted capital plans to the Federal Reserve, which then tested those plans against simulations of extremely adverse market conditions – what some consider to be an even worse scenario than the 2008 financial crisis.

In the end, 15 of the 19 plans passed muster, with only Ally Financial, MetLife, SunTrust, and somewhat surprisingly, Citigroup’s, plans being rejected by the Fed. The upshot to this action is that those four institutions won’t be able to increase dividends to shareholders or buyback shares – moves that would benefit investors but weaken the banks ability to survive another financial crisis.

The nightmare scenario envisioned by the Fed in these tests was a crisis that triggers 13% unemployment, a 21% drop in housing prices as well as economic slowdowns in Europe and Asia. The Fed was forthright about the tests as well, releasing an 82-page report detailing its methodology and assumptions.

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A decided lack of transparency caused many to question the motives of the previous Federal Reserve-supervised stress test. A recent report by ProPublica details how many thought that it was more a ploy to goose confidence in the banks than an honest effort to test their ability to withstand another crisis. The results of that test were not made public, even though it resulted in many of the banks being once again allowed to return capital to shareholders.

But the initial market reaction seems to offer a vote of confidence for the rigor of this most recent edition. JPMorgan, which announced Tuesday that it would be increasing its dividend and authorizing $15 billion in stock buybacks, saw it’s shares surge 7% on both pieces of news. Bank of America, another large bank, saw its shares rise 4.1%. Likewise, banks that failed the test saw their stock prices slump.

This may seem like a matter of course, but if investors were skeptical of the Fed’s methodology, one would not expect stock movements to be so strongly correlated with the Fed’s impression of bank financials.

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The release did not come without hiccups or its skeptics. Firstly, the Fed wasn’t even planning to release the results of its test until today. According to a Bloomberg report, the central bank moved up its announcement to Tuesday because it was concerned about details of the report leaking. And while other banks waited until after the Fed made its announcement to publicly state its capital plans, JP Morgan jumped the gun, which some investors interpreted as a snub to the Fed. JPMorgan CEO Jamie Dimon has publicly chafed against increased oversight post-crisis.

Other market watchers were skeptical of the process itself. Christopher Whalen, a bank analyst and frequent critic of the big banks, penned an article in ZeroHedge questioning the assumptions, both by the Fed and the banks themselves, that went into the tests. It’s well known that housing remains a thorn in the side of the big banks, and depressed real estate prices are the biggest risk to bank balance sheets. The banks are making their own assumptions, however, with regards to the value of their real estate holdings, and Whalen is dubious of what the banks are reporting on their balance sheets. The Fed, he says, is happy to go along with this massaging of the data. He writes,

“The Fed does not want to believe that there is a problem with real estate. As my friend Tom Day wrote for PRMIA’s DC chapter yesterday: ‘It remains hard to believe, on the face of it, that many of the more damaged balance sheets could, in fact, withstand another financial tsunami of the magnitude we have recenlty experienced and, to a large extent, continue to grapple with.’ “

Even those that are more credulous are taking exception to the Fed’s decision to allow the banks to increase dividends and stock buybacks. The Bloomberg editorial board wrote an opinion yesterday criticizing this decision:

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“Good as the stress tests were, they don’t mean the U.S. banking system is out of the woods. Three major banks — Ally Financial Inc., Citigroup Inc. and SunTrust Banks Inc. — didn’t pass, and investors still don’t have much faith in the reported capital levels of many of the rest. If the Fed wants the positive results of the stress tests to last, it should err on the side of caution in approving banks’ plans to pay dividends and buy back shares — moves that benefit shareholders but also deplete capital.”

So there’s still plenty for skeptics to read into Tuesday’s report. For those who want to doubt the veracity of the banks’ bookkeeping, you can look to Whalen’s report. For those who like to question the Fed’s decision making, Bloomberg’s argument is as good as any. But at the same time, we all know from experience that things could be much worse, and Tuesday’s announcement appears to be another in a string of recent good news that, unfortunately, comes packaged with a few caveats. When all is said and done, this most recent test may turn out to be another small, “I think I can” from the little recovery that could.

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