FYI | Mar 14 2012
By Greg Peel
I suspect the US Federal Reserve is a little bit peeved with Jamie Dimond, CEO of JP Morgan Chase, even if JPM is the Fed's poster child. The plan was for the Fed's stress test results to be released on Thursday but clearly Dimond was like a kid on Christmas morning and just couldn't wait.
It is a well known fact that thanks to tighter lending, an improving US economy and buckets of cheap money from the Fed which US banks have deigned to keep for themselves, US banks have been sitting for some time on piles of cash. Having settled their TARP debts from 2008, the big US banks have been keen to take advantage of that cash. One way would be to start lending it freely into the economy once more.
But let's not be too hasty. America is still trying to wobble its way out of the GFC and subsequent European crisis. Too much cash not being “put to work” thus undermines earnings per share growth potential, so the US banks need another way to improve shareholder returns and help lift share prices further out of the 2008 depths. The obvious way is to increase dividends, providing shareholders with a more attractive yield in a very low US yield environment, and/or to use the excess cash to buyback shares, thus improving EPS from the denominator line.
But the Fed will no longer allow the US banks to enact such capital management until they pass a set of annual “stress tests”. The Fed has recently been conducting these tests, which ostensibly evaluate whether the banks are sufficiently capitalised and liquid to endure any further major economic shocks such as, perhaps, the collapse of the euro currency. The ECB also conducts such tests regularly but has always come under criticism for being too lenient in its criteria. The Fed's tests, on the other hand, are quite stringent.
Last night the Fed told JP Morgan it had passed, so Jamie Dimond wasted no time in announcing a bigger than expected dividend increase and a much bigger than expected share buyback program, leading to last night's financial sector-driven rally. The Fed suddenly realised the cat was out of the bag and that Wall Street was now speculating on other banks. Bernanke decided he better bring forward the stress test results announcement to after the NYSE close this morning.
Before the market had closed, however, Bank of America was quick to announce it would neither be increasing its dividend not buying back shares. But this was not unexpected, and BofA shares still finished up 6% on the day (JPM 7%). The real speculation was as to whether Citigroup would follow JPM's lead, and its shares were also up 6%. Not everyone was so sure, however.
Well as it turns out, Citigroup is not allowed to make any changes because it has failed the stress test. Citi shares are down 3.4% in the after-market. The smaller Ally, Suntrust and MetLife were the other three banks to fail the test, but this means 15 banks passed.
Citi's capital ratio was quite sufficient – among the higher in the group – but the Fed's tests assumed a 50% drop in stock price, 21% fall in housing prices, a 13% unemployment rate, and a deeper than expected recession in Europe. Citi failed on its home and other loan books. Citi was planning to raise its dividend, but will now have to reassess its position.
The good news is that the news of the four failures, and particular that of Citi, has not appeared to dampen general Wall Street enthusiasm. The Dow futures are a reasonable off-market guide, and they are little changed on the news.
While US bank stocks have joined in the Wall Street rally from the depths late last year, they had stalled at the recent hurdle and not allowed the Dow to conquer 13,000. A US bull market cannot proceed without the financials, any US investor would tell you, so the banks were a missing ingredient. But last night's news seems to have changed all that, at least in the immediate term.
We recall that it was the banks which led Wall Street out of the big GFC slide in March 2009. Can the US banks lead another leg of a rally? The difference is 2009 saw a turn off the bottom whereas 2012 has already seen a 20% rally. But after those dim, dark European days, suddenly everyone on Wall Street is smiling.
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