In an effort to update you on the Accuvest “U.S. Banking & Financial Services” investment theme, we have restated the core tenants of our positive outlook in 3 points below. In addition to monitoring these primary drivers, we are interested in the recently released results of the Federal Reserve’s Comprehensive Capital Analysis and Review – March 2014. Specifically, we would like to confirm that the results of this “stress test” add support to point number two below: reduced risk.
The Investment Thesis: Value, Limited Downside, and Interest Rate Hedge
- U.S. bank stocks have revalued during the past couple of years to trade at about 1.1x book value and 1.5x tangible book. Earnings have risen to a record high from cyclical lows. Cost-cutting should improve profitability and lower litigation charges should help large banks. Rising capital allows for growing excess to return to shareholders.
- U.S. banks have reduced problem assets during the past few years through charge-offs, write-downs and asset disposals. This has enhanced their ability to withstand macroeconomic challenges compared with when they entered the financial crisis. As balance sheets improve, the increasing quality of the loan book may enhance value protection and reduce risk.
- Rising long-term rates are driving a steeper yield curve, which should be positive for U.S. regional bank net interest margins. Consensus expects curve steepening. Large banks earn 61% of revenue from interest income, while banks with less than $1 billion in assets earn 77%.
The Stress Test
- The Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) expanded this year to include 30 banks, up from 18 in 2013. Most of the added banks were part of the Fed’s 2013 Capital Plan Review. In the more stringent CCAR, the Fed’s assessment is based on estimates derived from its own models.
- In the Federal Reserve’s 2014 severe stress test scenario, the key added international assumption is a slowdown that originates in developing Asia economies in addition to a China slowdown. This contrasts with 2013′s test which assumed only spillover effects of a China slowdown. The result is a more dramatic slowdown to both these economies and that of Japan. Citigroup, Goldman Sachs and Morgan Stanley earn a relatively higher share of revenue from Asia.
- The key change in the Federal Reserve’s domestic assumptions for the 2014 severe-stress scenario is a sharp reversal in the U.S. real-estate market recovery, with home prices falling 25% and commercial real estate 35%. U.S. mortgages are a median 44% of stress-tested bank portfolios. Unemployment should rise another 4%, though a lower 7% start may drive an 11% peak vs. 12% in the 2013 test.
- The 35% decline in commercial real estate (CRE) prices in the Federal Reserve’s 2014 stress test is more than the 21% drop in 2013′s test. CRE is a median 12% of stress-test banks’ loan portfolios, led by Zions (47%), M&T (42%), Santander’s U.S. unit (35%), BB&T (25%), Comerica (23%) and Regions (23%). In 2013, the Fed used an 8% average assumed loss rate, with a higher 9.7% for Regions and a lower 7.1% for BB&T.
- Banks with large trading businesses are required to estimate losses from a market shock scenario similar to that of 2H08, adjusted to include more severe shocks to emerging-market sovereigns and corporates, European sovereign and financial stress, and rising global long-term rates. Declines of about 35% in world equities and 58% in commodities are similar to 2013′s test. The banks include Goldman Sachs, Morgan Stanley, Citigroup, JPMorgan, Bank of America and Wells Fargo.
- In 2014, the eight systemically important banks – custodians BNY Mellon and State Street and the six trading banks (above) – must calculate losses from an instant, unexpected counterparty default in derivatives and securities financing transaction scenarios. This includes securities lending, repurchase and reverse repurchase agreements. Banks must incorporate the default with the largest net stressed losses, excluding G-7 sovereigns and systemically important clearing utilities.
The Results