The Anatomy of the stress test | Fool.com gets it | The Banking and Strategy Initiative

Apr 29, 2009

The Anatomy of the stress test | Fool.com gets it

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One part of Treasury Secretary Geithner’s plan to prop up the failing bank sector is a forward-looking “stress test” imposed on every bank with over $100 billion in assets. Those failing the test would have access to contingent capital that could, thought goes, keep them alive — or zombified, depending how you look at.

As was the general theme of Geithner’s announcement, no details of how such a test might work were disclosed. Here’s what the Treasury gave us:

A key component of the Capital Assistance Program is a forward looking comprehensive “stress test” that requires an assessment of whether major financial institutions have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected.

How the Treasury — who didn’t see this massacre coming in the first place — expects to accurately predict what sort of massacre lies ahead is beyond me. I assume they’ll come up with some fancy-pants formula to model a “worst case” scenario, and then extrapolate whether a bank currently has enough capital to survive. Again, no one really knows. These assets are impossible to value, so it’s impossible to determine exactly how much capital a bank really needs.

But I’ll still try

At any rate, I threw together a stress test of my own, however imperfect. I used just one statistic: the tangible common equity ratio. Why? Of all of the capital adequacy measures, I feel it’s not only the most accurate, but the most meaningful to average Joe common shareholders.

My test was pretty simple:

I looked at banks’ tangible common equity (TCE) ratio at the end of 2008 and compared it to the end of 2007. This gives a rough estimate of how common capital position changed over the past year.

I then took the percentage change and applied it to today’s TCE ratio, in effect giving it a forward-looking “stress test”.

Why do I feel these assumptions are useful? Two reasons: (1) While far from perfect, it gives us an indication of asset quality, and (2) most credible estimates predict we’re only a fraction of the way through total credit writedowns. Therefore, whatever carnage was inflicted in the past year could easily repeat itself — perhaps on a larger scale — in the next.

Now, I admit: This analysis is crude, rudimentary, and deserving of hole-poking. It’s intentionally simple because, more often than not, complexity leads analysis astray. I’m not claiming it to be perfect, because, well, it isn’t. There are a zillion variables it ignores. On a broad basis, however, I think it provides a practical look of where big banks are heading.

Without further ado, let’s take a look:

Bank 2007 TCE 2008 TCE Forward-looking TCE

JPMorgan Chase (NYSE: JPM) 4.05% 3.31% 2.70%

Citigroup (NYSE: C) 2.27% 1.19% 0.63%

Bank of America (NYSE: BAC) 2.99% 1.97% 1.30%

Wells Fargo (NYSE: WFC) 2.94% 2.25% 1.73%

US Bancorp (NYSE: USB) 3.94% 2.62% 1.74%

Goldman Sachs (NYSE: GS) 2009 7.55%*

Morgan Stanley (NYSE: MS) 2009 7.52%*

Source: Capital IQ, a division of Standard & Poor’s, and author’s calculations. Bank of America’s calculation doesn’t include Merrill Lynch — combined company data unavailable. *Raised TCE ratios in 2008.

A few thoughts

Scary numbers, Fools. According to RBC Capital Markets, TCE above 6% has been a historical norm.

Once you get into the 1%’s — where some banks are today — common shareholders are holding on for dear life. Below 1%, and it’s likely gameover.

Therefore, Citigroup, almost any way you spin it, is headed for zombie land. Bank of America (even without calculating the effects of Merrill Lynch) isn’t far behind. Of the major commercial banks, JPMorgan appears to be best of breed, but hardly qualifies as “safe”. Investment banks Goldman Sachs and Morgan Stanley actually strengthened their TCE ratios in 2008, as they were able to shed assets and de-lever much faster than others. How long that can continue is anyone’s guess. I wouldn’t bet on it.

What’s the takeaway here? My belief is that most investors should avoid all bank stocks like the plague, at least until details of the pending “aggregator bank” Secretary Geithner’s working on become clear. There may indeed be some incredible bargains in bank stocks today, but with this much uncertainty you won’t know what’s cheap until after the fact. There’s plenty of opportunity today. Just don’t waste your time digging for it in bank stock

via http://www.fool.com/investing/dividends-income/2009/02/12/which-banks-might-fail-the-stress-test.aspx