Which Banks Might Fail the Stress Test?

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 tangible common
equity/ assets

2008 tangible common equity/assets

Forward-looking tangible
common equity/assets

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  )

5.08%

6.19%

7.55%*

Morgan Stanley (NYSE: MS  )

2.50%

4.33%

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 stocks.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase is a current and Bank of America is a former Motley Fool Income Investor recommendation. The Motley Fool is investors writing for investors.


Read/Post Comments (7) | Recommend This Article (35)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 12, 2009, at 2:54 PM, CAPSnGAIN wrote:

    Thank you for a useful article. With traditional financial models falling short in the current environment, I like seeing others attempts at coming up with a better model.

    I don't hold out great hope for the financial "stress test". If one in seven mortgages really are underwater, at lot of these "bad assets" are probably not worth anything, so any longer-term model will only inflate the value of some of these assets.

    Will the stress test really weed out the zombies and cause asset sales to stronger banks, or will it "inflate values", and try to sucker more investors in by painting a rosy picture of the future? So far, the second has been the preferred approach, rather than taking a conservative view, and a "one-time" hit, followed by putting the trillions into solving any fallout, and then watch things recover as people start to trust the banks balance sheets again.

  • Report this Comment On February 12, 2009, at 4:30 PM, carolina1954 wrote:

    Your numbers for Bank of America appear to be wrong. As shown in BAC's 2008 earnings presentation, available on their website, BAC's tangible common equity ratio at year end 2007 was 3.35% and was 2.83% at year end 2008. The same source indicates that the proforma TCE ratio including the Merrill acquisition is 2.6%. The calculation of TCE ratios is well understood and simple, so I don't understand how you could have gotten it wrong, unless you are using an unconventional TCE concept. If so, you ought to disclose it.

    You also state that "some banks" are "today" in the 1% range of TCA/assets. I'm not aware of any major bank in this situation. Please don't be coy with your data--tell us which banks are in the 1% range.

  • Report this Comment On February 12, 2009, at 4:33 PM, carolina1954 wrote:

    Your numbers for Bank of America appear to be wrong. As shown in BAC's 2008 earnings presentation, available on their website, BAC's tangible common equity ratio at year end 2007 was 3.35% and was 2.83% at year end 2008. The same source indicates that the proforma TCE ratio including the Merrill acquisition is 2.6%. The calculation of TCE ratios is well understood and simple, so I don't understand how you could have gotten it wrong, unless you are using an unconventional TCE concept. If so, you ought to disclose it.

    You also state that "some banks" are "today" in the 1% range of TCE/assets. I'm not aware of any major bank in this situation. Please don't be coy with your data--tell us which banks are in the 1% range.

  • Report this Comment On February 12, 2009, at 11:36 PM, jerryguru69 wrote:

    You took the words (not to mention a potential post) right out of my mouth before I could nail down a few numbers. The Japanese economy suffered in limbo because they refused to allow "zombie banks" to fail. We could suffer the same fate. Tops on my list of American Zombie Banks that should be allowed to fail:

    BA, WFC, C.

    Until this happens, we will not recover.

  • Report this Comment On February 13, 2009, at 2:29 PM, momnurse999 wrote:

    We are all ignorant..Just about different things:)

  • Report this Comment On February 13, 2009, at 3:10 PM, jsextoncol wrote:

    While the idea of a stress test is a useful exercise, the one presented is overly simplistic. In particular, three adjustments should be made: 1) assets whose losses are covered by the FDIC or other government entities (see US Bancorp in particular) should be excluded, 2) minimal risk assets such as cash and investment securities should be excluded, and 3) loss reserves in excess of the industry average (or short of the average) should be included in tangible equity. For example, US Bancorp and JPMorgan have particularly strong loss reserve positions. Finally both firms significantly added to loss reserves while remaining profitable in every quarter during 2008. When adjusted for these variables, JPMorgan and US Bancorp are in pretty good shape. Both have strong loss reserves, meaningful core profitability and adequate capital to weather the storm. In contrast, investments in many other banks basically represent a call option on the forward performance of the US economy.

  • Report this Comment On March 04, 2009, at 1:02 PM, tmeyers442 wrote:

    WAMU had a TCE ratio of 7.8 right before the feds took it over that Thursday night. Lost a lot of money investing based on the TCE ratio.

Add your comment.

DocumentId: 830869, ~/Articles/ArticleHandler.aspx, 4/18/2014 5:06:21 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement