With all the hoopla leading up to yesterday's release of the banking stress tests, the results may be more than a little anticlimactic. And maybe that's not that surprising, because while there was definitely an element of real stress testing involved in the assessment, it was also a government PR campaign on behalf of the banking system.
And since the market doesn't dig surprises, the regulators were even kind enough to "leak" results in the days leading up to the final release, so that digestion could take place slowly. By the time the full results hit the wires, we already knew that Bank of America (NYSE: BAC ) , Wells Fargo (NYSE: WFC ) , and Citigroup (NYSE: C ) would have to raise new capital. Likewise, we were told that Goldman Sachs (NYSE: GS ) , MetLife, and Capital One (NYSE: COF ) were in the clear.
But now that the stress test results are out, we do have a fair amount of new information. Some of it is actually about the banks, but some of it is also about the government's perception of the banks and how it will treat them in the future.
So, taking this new information into account, should the bears retrench or the bulls start charging? Let's take a look.
The bear case
The total amount of capital that the banks need to raise undershot what many investors were expecting, and was well below what some of the most bearish market watchers were proclaiming. One of the main reasons for this was that banks projected out their revenue over the period covered by the stress tests, and could use that to absorb some of their projected loan losses.
Sounds fine, right? Well, what we need to remember is that the Federal Reserve is holding interest rates at absurdly low levels, and any bank that can lend at reasonably high rates and borrow at next to nothing is going to be raking it in. If interest rates were brought back up to more realistic levels, the banks might be looking at a much different picture.
It's also been widely questioned just how stressful these tests actually were. In the "adverse" scenario, it would have been good to see the regulators really turn the screws on the banks. Instead, we got something more akin to patty-cake. Assumptions of a 3.3% decline in GDP this year and 10.3% unemployment next year, sadly, aren't all that far-fetched, so it's tough to call them terribly adverse.
And finally, with all of the talk of financial institutions that are too big to fail, the government has aided and abetted these massive institutions in getting even larger -- yes, I'm looking at you JPMorgan Chase (NYSE: JPM ) , aka JPStearnsMutual. Will the government flip 180 degrees at some point and decide that it's time to shrink the banking giants? Don't ask me. If there's anyone more unpredictable than Mr. Market, it's Uncle Sam.
The bull case
If you can't beat 'em, join 'em, right? That alone is a pretty good bull case for the big banks, because it's tough to swim upstream when the government is rushing downstream like a money-printing tsunami.
One of the things that the stress tests have made crystal clear is that the government wants to keep the big banks alive -- and it wants to keep them in private hands. It even introduced a new Mandatory Convertible Preferred security that would help banks meet capital requirements without being actual, voting common equity unless converted down the road.
Investors in the big banks can feel pretty secure knowing that the most powerful government in the world is ready to pull out all of the stops -- or continue pulling out all of the stops -- to make sure the major banks stay on their feet.
Additionally, while bank valuations have been difficult to tackle lately because of the specter of losses, the results of the stress tests can help us with that. Take BB&T (NYSE: BBT ) , for instance. If we apply the projected losses less projected income to its current book value, and slap on the bank's 10-year average book value multiple -- which is around 2.3 -- we can see the potential for BB&T's stock price to be significantly higher at the end of 2010. And that's assuming the Fed's "more adverse" scenario of losses.
Forget the broad brush strokes
A bank is a bank is a bank, is not the way to think about the financial industry right now. My feeling is that investors can do well in the financial industry, but they have to be choosy. Bank of America and Citigroup both still have a lot of question marks -- particularly how B of A is going to come up with the $34 billion that the Fed wants it to raise. And maybe I'm just crazy, but I'm not quite as sure about Wells Fargo as Warren Buffett is.
However, looking through the list of banks that went through the stress tests, there are definitely some solid institutions there ready for the picking. So let's cut the jibber jabber and get to picking already.
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