Did Federal Reserve Bank Stress Tests Fuel Too Much Confidence?

The Federal Reserve released the results of its third round of bank stress tests yesterday (Tuesday), determining 15 of the 19 tested banks were in good enough shape to withstand a severe recession.

The Fed tested whether banks have enough capital to survive an unemployment rate of 13%, a 21% drop in home prices, slowing economic growth in Europe and Asia, and a 50% drop in stock prices.

The tests assumed that banks would face $534 billion in losses in just over two years, and measured how much capital remained. The Fed earmarked $341 billion of those losses for loan portfolios.

The results of the bank stress tests show how institutions have worked to shore up balance sheets in the wake of a crisis - but can simulations really prove that banks won't fail?

Bank Stress Tests Fall Short

Banking industry insiders say the tests are exaggerated versions of dismal conditions, and consumers and investors can be confident in banks that pass.

"When you put banks under the kind of dramatic scenarios that the Fed did - and they are still doing well - it tells you how well capitalized the majority of the banks are coming out of this downturn," Michael Scanlon, senior equity analyst with Manulife Asset Management, told The New York Times.

But analysts pointed out the bank stress tests only measured if banks would survive a crisis similar to the one we faced before - and the Fed still failed to address how banks had trouble borrowing money in the markets during the financial crisis.

Independent bank analyst Christopher Whalen told CNNMoney that stress tests also included a rosy outlook for the legal liabilities the banks still face from the mortgage crisis.

Bank of America Corp. (NYSE: BAC) passed the tests, but still has large holdings of home loans. Its high residential mortgage market exposure could cause it to struggle greater than the Fed predicted. Pair its loan portfolio losses with its legal costs related to mortgages and BAC's liabilities could be as much as $80 billion, not the $60 billion estimated by the Fed.

What the tests have clearly highlighted is the uneven nature of the financial sector's recovery, and widened the gap between stronger and weaker banks.

"Some banks are better positioned than others, and you're going to see them start to steal some market share and sort of separate themselves," William Fitzpatrick from Manulife Asset Management told Bloomberg News. "We're going to see some separation from the winners and the ones that didn't pass."

Banks Raise Dividends - Too Soon?

A number of dividend increases were announced by passing banks after results of the bank stress tests were released.

JPMorgan Chase & Co. (NYSE: JPM) announced it would raise its quarterly dividend by 5 cents to total 30 cents, and plans to buy back at least $15 billion of its stock through 2013.

Wells Fargo & Co. (NYSE: WFC) said it would raise its dividend by 120% to 22 cents, US Bancorp (NYSE: USB) announced a 56% dividend hike and 100-million share buyback, and BB&T Corp. (NYSE: BBT) said it would boost its dividend 25% and said it may redeem $3.2 billion of preferred trust securities without raising replacement capital.

Some analysts said it was too soon for the Fed to approve such capital expenditures, despite the apparent severity of the stress test metrics.

Stanford University professor of finance and economics Anat Admati said it was "irresponsible" of the Fed to allow capital depletions because it increases banks' vulnerability.

For example, Wells Fargo passed the test but still has an unstable credit card portfolio. And US Bancorp has a business loan portfolio on par with Citigroup Inc. (NYSE: C), which failed.

Four that Failed: C, STI, MET, Ally

Citigroup, SunTrust Banks Inc. (NYSE: STI), MetLife Inc. (NYSE: MET), and Ally Financial were the four banks that failed the Fed's examination.

Under part of the test, Citi's capital dropped to a critically low 4.9% of assets. The Fed said Citigroup also had a weak loan book, and if under extreme stress would lose 9.7% of its first mortgage loans. Citi had the worst business loan portfolio, too.

Citigroup stock was down 6.3% Tuesday, and it continued its slump Wednesday to fall another 3.4%.

Ally Financial and SunTrust performed worse in the tests, mostly due to exposure to bad mortgages.

The Fed rejected Citi's proposal to return capital to shareholders due to its test failing. Citigroup said it would resubmit a plan later this year.

U.S. Finance Stocks Get Boost

The financial sector soared Tuesday ahead of bank stress tests.

JPMorgan rose 7%, Goldman Sachs Group Inc. (NYSE: GS) was up 6.5%, Bank of America climbed 6.3%, and Wells Fargo was up 5.8%.

The KBW Bank Index (BKX) rose 4.6% and continued its gains today (Wednesday) rising 1.24%. The index has shown a return to U.S. banking confidence this year. It's up 21% in 2012 after plummeting 25% last year, its worst annual performance since 2008.

News and Related Story Links: