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 Federal Reserve approved 25 of 30 banks’ capital plans after a second round of stress tests including the impact of requested capital actions.
- Of the 30 banks tested by the Fed, only Zions did not meet the minimum 5% Tier 1 common capital ratio target in the severely adverse scenario. Results generally in-line with expectations should support banks’ announcements of payout increases following the announcement of test results including capital plans.
- Most listed U.S. banks subject to the Federal Reserve’s Comprehensive Capital and Analysis Review raised shareholder payouts after passing stress tests incorporating increases. Dividends and buybacks are a core portion of expected returns for bank shareholders, and the largest banks’ ability to potentially meet Basel III hurdles years early, along with consensus-expected profit growth, may allow for greater capital returns.
- The Federal Reserve objected to capital plans from the U.S. units of three overseas banks, HSBC, RBS and Santander, which were all new to the Federal Reserve’s Comprehensive Capital and Analysis Review this year. While each exceeded the 5% stress test minimum, the Fed cited “sufficiently material” deficiencies in capital-planning processes. All three are barred from implementing capital plans and must resubmit proposals after addressing the issues leading to the objections.
- Citigroup’s plans for an increase in its quarterly dividend to 5 cents per share and a $6.4 billion buyback were objected to by the Fed on qualitative grounds. Bank of America announced a 5 cent dividend, in line with expectations, and a $4 billion buyback, which is less than last year’s $5 billion. Its plan won approval only after reductions. Both banks have trailed peers’ dividend raises in recent years and were conservative in 2013 total requests after previous denials.
- Goldman Sachs and Morgan Stanley both passed tougher Fed stress scenarios, incorporating counterparty defaults in addition to a global market shock. Goldman revised its capital plan to gain approval. It didn’t announce the details, in keeping with previous years. Morgan Stanley, having digested the Smith Barney brokerage acquisition, doubled its quarterly dividend to 10 cents per share, above the consensus 8 cents estimate. It also announced a $1 billion buyback.
- The BBSTI Index, comprised of banks facing the 2014 Comprehensive Capital Analysis and Review, has appreciated 2.5% through mid-March, outperforming broader U.S. financials (0.5%) and world financials (down 0.1%). Bank of America (10.2%), Regions (7.9%) and PNC Financial (6.7%) lead performance among these peers, and have relatively higher capital return expectations.
- PNC’s stock has been one of the best performing among peers ytd, returning 9.7% vs. 4.4% for large and super-regional banks. After digesting its acquisition of RBC’s U.S. retail business, PNC’s 9.4% capital ratio is well above its target and up 190 bps yoy. PNC plans to use excess capital to increase shareholder payouts pending Federal Reserve approval, helping raise its ratio from 18% in 2013, closer to the capital review banks’ median of 43%.
- U.S. Bancorp has the highest ROE among U.S. regional and diversified bank peers and an 8.8% estimated 4Q Basel III Tier 1 common ratio, key indicators for capital return. Management retains its 60% to 80% capital return goal, and said it was about at the midpoint of that range in 2013. Its ratio is a bit lower using net share repurchases. Current and projected ROEs are above peers such as JPMorgan and Citigroup.
- Citigroup earns more than 50% of revenue outside the U.S., with likely more than 40% from emerging markets. Goldman Sachs (42%) and Bank of New York (37%) follow, though the latter’s business may be less cyclical. Harsher developing Asia assumptions include a 2.8% GDP contraction trough vs. 0.3% growth in 2013’s stress test, while Japan contracts 10.8% vs. 6.8%. Euro zone assumptions are similar, though the U.K.’s 3.6% contraction is more benign than 6.6% prior.
- Wells Fargo has the highest residential exposure of public peers (42%). HSBC’s subsidiary (52%) and Mitsubishi UFJ’s UnionBancal (42%) also have large concentrations. A 25% drop in home prices is tested vs. 21% in the 2013 test, though trough prices are 4% higher with a healthier start. Wells Fargo is expected to withstand this stress, with a total payout that may rise 80%, according to a Bloomberg News survey.
- Public U.S. banks subject to Federal Reserve capital review are expected to raise dividend payout ratios following approval of capital plans. Payout ratios will rise to about 25% in 2014 and 27% in 2015, based on consensus estimates. Banks paid out about 23% of earnings in 2013 and 21% in 2012, an improvement from the 15% to 20% of 2011 and 5% to 10% in 2010. These banks have historically returned 35% to 40% of earnings through stock dividends.
- Lenders have announced more than $60 billion of dividends and stock buybacks after the Fed released the 2014 CCAR results.
- Banks in this year’s test collectively received approval to pay out about 60 percent of their estimated net income during the next four quarters. That ratio is closer to the 69 percent that lenders were returning to shareholders in 2005 before the crisis.
In conclusion, we reaffirm our recommendation for U.S. Banking and Financial Services as a satellite equity investment. The Federal Reserve’s “Stress Test” reinforces a constructive outlook and conservative risk profile for U.S. Banks. The positive results confirm that U.S. banks have enhanced their ability to withstand macroeconomic challenges by reducing problem assets during the past few years. Equally important, the financial sector appears to be more exposed to a key driver of the broader equity market advance over the last few years: share buyback programs and increasing dividends.
Tags: C, GS, MS, ZION, M&T, BSBR, BB&T, CMA, RF, JPM, BAC, WFC, STT, BK, HSBC, RBS, PNC, USB
Sources: Comprehensive Capital Analysis and Review 2014: Assessment Framework and Results, and Bloomberg Research
The opinions expressed in this report are those of the author. The materials and commentary are strictly informational and should be used for research use only. This bulletin is not intended to provide investing or other advice or guidance with respect to the matters addressed in the bulletin. All relevant facts, including individual circumstances, need to be considered by the reader to arrive at investment conclusions that comply with matters addressed in this report. Charts and information used in this report are sourced from Accuvest Global Advisors, unless otherwise noted. Stress test results have been sourced from Bloomberg. Past performance is not indicative of future results. Remember that investing involves risks, as the value of your investment will fluctuate over time and you may gain or lose money. Investment risks are born solely by the investor and not by AGA.