We were more than a little surprised to read a Bloomberg story on March 10, which reported that the Federal Reserve was giving banks a hard time over its latest stress tests, particularly on the possible losses on consumer debt if the economy were to take a dive. The story indicated that if the Fed held tough, major banks would be restricted in making dividends and buying stock. This seemed to be quite a volte face from the Fed’s previous “give banks everything they ask for and then some” posture. But some Fed defenders argued, no really, once the banks were out of confidence crisis land, the regulators always planned to get tougher with them about building up their capital bases.
If today’s Bloomberg story is accurate, whatever resolve the central bank had was awfully short lived:
Wells Fargo & Co. (WFC) and Citigroup Inc. (C) may join banks unleashing more than $9 billion in dividend increases and share buybacks if they get passing grades this week on the Federal Reserve’s annual stress test.
Thirteen of the 19 largest U.S. lenders may say they’ll pay out $3.79 billion in extra dividends this year and buy $5.52 billion of additional shares, according to estimates of six analysts compiled by Bloomberg. That’s 30 percent more than they spent last year. San Francisco-based Wells Fargo probably will offer the biggest difference at a combined $4.16 billion, followed by Citigroup with $2.92 billion.
Now narrowly speaking, the two stories do not contradict each other. The later, cheerleading story, reflects analysts’ expectations, not any new information from the Fed. The earlier piece also noted that Mr. Market would be disappointed if the big banks (ex Bank of America) were restricted in their use of funds.
Now if we really believe that the Fed might have concerns about the solidity of bank balance sheets, which would be consistent with their super low interest rate largesse, why might they back off? Political scientist and leading expert in money in politics Tom Ferguson points out that any Republican presidential nominee, including Romney, is certain to be tougher on the Fed that Obama would be. He argues if the Fed proves to be generous to the banks, its motivation is likely to include the idea that the banks will start being more generous to Obama (and Bernanke) since the Fed continues to watch their backs.
The Fed has released its methodology for evaluating the banks (hat tip reader Deontos). It describes a much more adverse scenario than was included in the 2009 stress tests:
…a deep recession in the United States, significant declines in asset prices and increases in risk premia, and a slowdown in global economic activity… real GDP is assumed to contract sharply through late 2012, with the unemployment rate reaching a peak of just over 13 percent in mid-2013. The scenario assumes that U.S. equity prices fall by 50 percent from their Q3 2011 values through late 2012 and that U.S. house prices fall by more than 20 percent through the end of 2013. Foreign real GDP growth is also assumed to contract, with growth slowdowns in Europe and Asia in 2012.
Sounds like Lehman lite, and the more dire scenario is based, as the report indicates later, on concerns about the Eurozone. The Fed stresses that this is a scenario and not a forecast.
This in fact is pretty grim, and I would have trouble believing that the Fed could justify anything other than having the banks build up more in the way of capital buffers. As we’ve discussed repeatedly, the four biggest banks have residential mortgage second liens that based on the most recent data are valued at $369 billion. My understanding is that they are marked at between 80% and 90% of face value (JP Morgan may have written them down a bit more) when second lien paper is trading in the secondary market at 30 cents on the dollar. If you assume an average of 85% of face and it needs to be 30%, that $369 billion is really $130 billion, meaning you’d have a nearly $240 billion hit. And that’s just a realistic current mark, not taking into consideration the extra damage occurring in the new stress scenario.
In other words, if any of the big four banks are allowed to pay dividends or buy back stock this year, you should regard it as a bit of electioneering by the Fed. The banks have a long way to go before they are healthy, and the central bank knows even as it pretends not to know that for public relations purposes.