Relief Following Resolution of the Bank Stress Tests

by Michelle Gibley, CFA, Senior Market Analyst, Schwab Center for Financial Research
May 7, 2009

Markets have been awaiting the results of government stress tests regarding the health of the largest U.S. banks since the tests were conceived at the end of February. Since that time, banks have announced first-quarter earnings that surprised to the upside and bank stocks have surged higher, taking the overall market along with them. However, the level of short interest on banks has risen.

The level of uncertainty regarding the outcome of the tests rose to a feverish pitch in the two weeks prior to the results, and it appeared that the results were leaked to the press in a coordinated fashion over the past several days. While the amount of capital needed by certain banks (and subsequent dilution of existing shareholders) to shore up their balance sheets is large on the surface, markets reacted positively because:

Stocks had likely priced in much higher levels of needed capital and dilution.
Most banks can satisfy the capital needs by simply converting preferred shares to common shares, implying they don't need to raise new capital.
The conclusion of the tests increases certainty about the possible adverse tangible book value banks face and gives investors better ability to apply trough valuations on banks.

Tests measure amount of bank capital that could be eaten up by potential future losses
Credit quality deterioration is a natural outcome of a recession—job losses rise, credit card delinquencies spike, mortgages fall in value, and corporations close storefronts and/or go out of business. As a result, investors have been worried about the state of bank balance sheets, as banks have to raise reserves to cover increasing loan losses, cutting into the equity on balance sheets.

This decrease in equity lowers bank capital ratios, which need to meet certain minimum levels mandated by bank regulators. If these capital ratios aren't met, banks must raise additional capital, either through the equity or debt markets. However, investors have been extremely risk-adverse, unwilling to extend capital given the uncertain economy and destruction of wealth they have experienced in their investment portfolios. As a result, the government has stepped in as the lender of last resort, infusing capital to "bail out" the banks.

In order to restore confidence in the banking system—the lifeblood of the economy—the government conducted a series of stress tests on the 19 largest U.S. banks. The goal was to estimate the range of possible losses banks could suffer over the next two years if:

Unemployment rises to 10.3%.
Home prices, as measured by Case-Shiller, decline by 22% in 2009 and an additional 7% in 2010.
Gross domestic product contracts 3.3% in 2009 and 0.5% in 2010.

Banks are being told to hold additional capital to provide a buffer against losses that could occur in the likelihood the economy worsens further in the next two years. The government wants to make sure banks will have enough capital to still be able to lend in an adverse economic environment.

How will banks meet the capital requirement?
The banks that need to raise capital levels have until June 8 to develop a plan and must put the plan in place by November 9. The four basic options for coming up with capital include:

Taking additional government money under the Capital Assistance Program (the second round of the TARP).
Converting preferred stock to common equity.
Selling assets in the Public-Private Investment Program (PPIP).
Raising money from private investors.

Under all options except asset sales, existing common equity shareholder ownership would be diluted.

Without getting too technical here, it is important to understand some of the lingo to get better insight into to the reason the market reacted positively to the announcement. One of the measures of strength on which regulators are focused is a component of Tier 1 capital called tangible common equity (TCE). The relevancy of common equity is that increasing loan losses can be offset against common equity, but not against preferred stock, which is considered a liability, much like debt.

A conversion from preferred stock to common stock gives banks the ability to better withstand losses. In theory, common stock can be wiped out in bankruptcy or bank failure, while liabilities such as debt and preferred stock are higher in the capital structure and receive some value in the event of bankruptcy, as negotiated in bankruptcy court. By converting preferred stock to common stock, a bank's capital position would be strengthened and the bank would be better able to withstand future losses—and this could be accomplished without additional government capital.

Additionally, the government is creating a new form of capital, called "mandatory convertible preferred," that can be counted as TCE, but allows the government to avoid immediately converting into common stock, and thus diluting existing shareholders. This would sit as "potential common equity" ready to go at a moment's notice.

Healthier banks must show that they can issue debt without the guarantees now being given by the FDIC before they are allowed to return TARP money. The banks also must demonstrate that they will be able to sell stock to private investors and pass a government stress test to show that they are strong enough to survive without taxpayer aid.

What is the current operating environment for banks?
The stream of earnings news flowing from bank earnings reports for the first quarter was largely better than feared. While loan losses continue to rack up, there were bullish aspects to the reports, including:

Increasing deposits.
Profitable fixed income trading.
Soaring mortgage applications.
An improving investment banking environment.

The positive sloping yield curve (long-term rates higher than short-term rates) enables banks to borrow (in the form of deposits) at low rates and turn around and lend at higher rates; profiting on the spread, or difference between the two rates. The first quarter results showed that despite increasing reserves for losses, the banks have largely been profitable on an operating basis.

While the government says it is making conservative estimates of future operating revenue and is using a severe but plausible estimate of future losses, investors need to weigh their confidence in the stress test estimates, as well as other factors, when considering owning shares. Things to consider include:

The amount and cost of new capital as it relates to the amount of dilution common equity shareholders would face.
Improving credit markets (debt and equity) may allow banks that need additional capital to raise money from private investors instead of the government. Additionally, there are reports of strong interest in the PPIP to remove toxic assets from bank balance sheets. Some banks may be able to sell healthy divisions to raise capital.
The economic outlook and impact on the trend of earnings revisions.
Whether the conditions powering strong first-quarter earnings are sustainable and/or if other divisions of their businesses can see renewed strength, enabling banks to earn their way out of the recession and avoid new infusions of capital.
Composition of bank assets: Sub-prime versus prime residential mortgages; commercial real estate (CRE); construction loans; commercial and industrial loans (C&I); and credit card portfolios are in different stages of their life cycles, and while much of the sub-prime write-downs are in the past, credit card, CRE and C&I portfolios continue to deteriorate and large measures of write-downs are yet to come. Keep in mind that securities are marked-to-market, while loans are held at their original cost using amortization rules, minus a reserve for losses.
Outlook for a stricter regulatory environment and less levered banks, and implications on future profitability, growth and valuations relative to the past.
Prospects for continued consolidation given likely over-supplied status of the banking industry.

What does it mean?
Concerns about bank nationalization and huge amounts of dilution and capital raising appear to be dissipating, taking the worst-case scenarios off the table for now. However, banks continue to face a difficult economic environment, deterioration in their loan portfolios and increased regulatory scrutiny. Financials tend to lead the market after an economic downturn, as shares start to discount the possibility of recovery.

Shares will likely be volatile while the market digests the results of the stress test and looks forward to what's next for the group, but for those interested in taking a more active approach to investing, see the bi-weekly Schwab Sector Views by Brad Sorensen. We currently have financials weighted marketperform, believing the recent rally may be a bit overextended in the near term. However, we urge investors who have shunned the group recently to use dollar-cost averaging to get back into the group, using pullbacks to bring their allocations up to market weight.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.

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