Stress-testing the big US banks

There has been a lot of speculation about the US Treasury's stress test that banks with more than US$100 billion of assets will be forced to go through over the next two months. With just a little guidance available, we decided to come up with our own stress test to see which banks may look short of capital and which ones are likely to pass the test without the need for back-stop government capital.

Out Test
With Tier 1 ratios at historic highs, we chose to focus on the tangible common equity/tangible asset ratio (TCE ratio) to determine the strength of the bank. Regulators have not given any guidance on what is an acceptable minimum TCE ratio for a bank, so we used a 3% minimum, which appears to be the minimum acceptable ratio in the market for now. Using our projected earnings numbers, the banks' loan books, and (for some) securities at risk for write-downs, we tried to assess how much stress 14 large US banks could take over the next two years before seeking government aid.

Like any quick-and-dirty analysis, our stress test will lack the sophistication of the government's much more detailed version and has some obvious weaknesses that need to be understood before using the results. The biggest drawback to this type of exercise is that we needed to standardise it. We use a flat loss rate across the industry despite the meaningful differences in loan portfolio mixes, underwriting standards, and loss recognition policies across the industry. We don't take into account the potential of writing down government-backed securities, positively affecting the outcome for the banks. We do not account for the capital drain of dividends or excess provision-building. We also use a stable pretax, pre-provision, pre-write-down earnings figure for all our scenarios, despite the likelihood that a deeper recession would probably lead to lower net interest margins, lower fee-based revenues, and higher operating costs. We don't give major acquirers (such as J.P. Morgan's purchase of WaMu or Wells Fargo's purchase of Wachovia) any credit for the mark-to-market accounting they used in acquisitions. We also keep the end-of-period balance sheet size stable--despite the obvious correlation between higher write-downs and a shrinking asset base. With these limitations in mind, we still found this exercise useful.

The Failing Banks
In our opinion, banks that fail to pass the stress test are not in danger of being seized by the FDIC (Federal Deposit Insurance Corporation). In fact, failing our test does not necessarily even require these banks to raise new capital. It would require the banks to at least negotiate with the government to convert some of the preferred stock received in the first round of the Troubled Asset Relief Program into common stock, which would dilute shareholders. With their current capital cushion and relatively small shortfall we believe that Bank of America, State Street, PNC, and KeyCorp would likely convert existing preferreds into common stock before seeking additional capital. The greater capital need displayed at SunTrust and Fifth Third leads us to believe they will need to seek new capital from the CAP programme and convert some of their existing preferred shares to fill their capital shortfall, forcing the current shareholders to take a much bigger hit. Citigroup took action last week to close its large tangible common equity shortfall, announcing a massive preferred stock conversion that could leave existing shareholders owning only 26% of the bank, while the government's stake could jump to 36% of the beleaguered company.

The Passing Banks
Passing the stress test is definitely good news, but it doesn't prevent the companies from facing significant challenges in the two years ahead. Loan losses and additional securities write-downs are likely to continue throughout 2009 and into 2010. As a result, even the strongest of the banks might be forced to cut their dividends. Not surprisingly, the better-capitalised banks are usually also the banks who were unwilling to take big risks with their balance sheets. We think these banks will both suffer smaller losses and more easily absorb those that do occur. Furthermore, strong banks like JP Morgan, Wells Fargo, US Bancorp, and BB&T will continue to benefit from a flight to quality by bank customers and investors. With strong management and a disciplined culture, these banks are likely to be hurt less in this downturn and stand in the best position to profit from the upheaval in the market in the long run.