Neither an unemployment rate of 12% nor a 5% plunge in GDP nor a 20% dip in home values nor a 50% plunge from the stock market (or any combination thereof) will be enough to put this nation’s banks in fiscal jeopardy … well, except one — Ally Financial (NYSE:GMA). All the other banks are more than adequately capitalized and shielded from whatever financial curveball the economy could throw their way.
That’s what the Federal Reserve says, anyway.
The government’s banking regulatory arm completed its now-annual review of the eighteen national banks it oversees, and said all of them passed the so-called stress test except Ally, the bank formerly known as GMAC. Passing the latest round of stress tests means they can start to return even more capital to shareholders who have been waiting patiently for rising dividends and stock buybacks.
Not all of these banks passed the test with flying colors, however, and as such, not all of these banks are equally worthy of your investment dollars.
The Biggest Loser
It was not really a surprise that Ally failed the test. The struggling entity was never even close to meeting the minimum Tier 1 common capital ratio of 5.0% going into the tests. In fact, Ally’s Tier 1 ratio fell from 2.5% last year to 1.5% this time around.
In simplest terms, the Tier 1 capital ratio compares a bank’s equity — which is relatively free of risk — to its risk-weighted assets like loans or investments. The Fed doesn’t require a great deal of cash or equity compared to a bank’s riskier assets; 5% is the current standard. But it also doesn’t take much economic turbulence to whittle down the marketable value of those risk-weighted assets, so the Fed closely scrutinizes both sides of the ratio.
In Ally’s case, it’s still got too many risky assets on the books, and/or not enough equity or cash. And the important takeaway for investors — that’s not apt to change anytime soon.
Again, the minimum score required to pass the test is a Tier 1 common capital ratio of 5.0%. Although the Fed considers it strictly a pass/fail question, the individual scores of all the tested banks are made public. At the bottom of the “pass” list are Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS). Both scored under 6.0%, compared to the top score of 8.3%.
Those scores are good enough to pass, but leave little margin of error should things turn south for the economy. The weaker score also means Morgan Stanley and Goldman will be able to distribute (relatively) less cash back to shareholders.
Not that they necessarily aced this year’s stress tests, but SunTrust Banks (NYSE:STI) and MetLife (NYSE:MET) are at least off the hot seat. Both banks failed their year-ago stress tests but passed this year.
Perhaps the biggest surprise from the latest round of scrutiny came from Citigroup (NYSE:C). After failing spectacularly last year, Citi’s Tier 1 ratio was a whopping 8.3% for the most recent round of testing. That means it’s going to be able to put more money back in investors’ pockets than most any other bank — a turn of events that’s even more pronounced given that the Fed put the brakes on its increased dividend and buyback hopes a year earlier. Indeed, Citigroup was the very first to publish its capital-return plan; it’s opting to buy back $1.2 billion worth of stock this year and will hold its quarterly dividend at $0.01 a share.
Most other banks are holding back on releasing their capital distribution plans until the Fed’s official report comes out this week. However, considering the Federal Reserve still has to approve each request for dividend increases and stock buybacks, that fact that Citi posted those details implies the Fed has already given the bank the green light for the $1.2 billion stock repurchase program.
The Last Word
All too often, the obvious trade isn’t necessarily the best one — the data is usually more than baked in by the time a trader can act on it, since everyone has access to the same encouraging information. In the case of the stress tests, though, the way things seem may well be the way to trade them. That means Citigroup should be at the top of your buy list, with Goldman Sachs and Morgan Stanley at the bottom. Ally isn’t even on the list.
At the time of publication, James Brumley did not have a position in any of the aforementioned securities.