Should Investors Stress Over the Coming Bank Stress Tests?

Michael Teague  |

The nation’s largest banks will be releasing the results of a new round of stress-tests this week and next.  On Thursday, March 7, banks will release the results of the Federal Reserve’s “Supervisory Severely Adverse Scenario” test.

The stress test is a hypothetical scenario in which the Fed attempts to assess how a given bank would perform in the event of a severe economic recession.  Some of the parameters of this situation include a five percent drop in GDP by the end of 2013, unemployment at or around 12 percent, a 50 percent drop in equity prices, a 20 percent drop in home prices, and increasing mortgage rates.

In terms of the global economy, the scenario envisions recessions throughout the Eurozone, the UK, and Japan, with a significant decline in Asian growth in tow (far more significant than was included in the same test-scenario the previous year), ostensibly in order to factor in fears of a slow-down in China.

The good news is that so far, there seem to be no expectations that any of the 17 publicly traded banks that failed last year’s tests will do as poorly this time around.

What is at stake in these tests for the banks and their investors however, is the Fed’s verdict on their capital distribution plans.  Depending on the results of the tests, the Fed will decide on the amount of stock each bank will be allowed to buy back, as well as the amount of dividends each will be able to pay out.

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A week later, on March 14, the results of a second set of tests will be released, assessing revisions from the results of the first round of tests, this time on a pass/fail basis, however.  Additionally, it is at this point that the Fed will give their final word on buyback and dividends plans.

Given the bullish trend that culminated in the Dow Jones Industrial Average (DJIA) surpassing its all-time high on Tuesday, it is easy to forget that the big banks, for all the blame and accusations they ritually face, are nowhere near the highs they experienced in the run-up to the Dow’s previous record-setting performance in October of 2007.  Indeed they have lagged behind the trend in this respect.

Citi Group Inc. (C), for instance, is still some 90 percent lower than its 2007 share-prices, while Bank of America (BAC) is about 75 percent removed. Goldman Sachs (GS) is trading for 30 percent less, Morgan Stanley (MS) 60 percent less, and Wells Fargo (WFC) is just breaking even.  This situation is largely the result of all the restructuring and deleveraging these institutions have been forced to do in various ways as a result of their various levels of implication in the mortgage crisis.

As information from the Fed’s stress tests begins to emerge on late Thursday and into Friday, there will be a clearer picture of the path forward for the nation’s largest financial institutions.  But this must be considered in concert with the fact that for now, it seems as though the banks are not being excluded from the most recent bull-trend.

Tuesday alone saw all of the banks on the Dow as well as all but one on the S&P 500 make gains between around one half of a percent to nearly 2 percent, including Bank of America, Citigroup, J.P. Morgan Chase (JPM), Wells Fargo, KeyCorp (KEY), and PNC financial services group (PNC).

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