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Bank stocks rallied after the stress tests were released earlier this month. However, fellow Fool Morgan Housel points out that there's a major flaw with forward-looking stress tests -- they're only as good as the assumptions used. I agree.
Is it wise for banks to reduce their capital now, as economic uncertainty still engulfs the world? Maybe not.
The Federal Reserve tried to ascertain whether banks had enough capital to survive in an environment where the unemployment rate would rise to 13%, housing prices would drop by 20%, and stock prices would fall by 60%. The scenario is quite bleak, but it overlooks potential legal liabilities from the mortgage crisis that banks have to face, the effect of possible interest-rate increases, and, if circumstances demand, from where and how they would borrow money.
I'm unimpressed with either the assumptions or the results of the tests. I don't think giving these banks a green light to boost dividends to the tune of $3.9 billion and undertake share repurchases worth a staggering $27 billion really qualify as positive moves.
Who's giving what
The biggest U.S. lender, JPMorgan Chase (NYSE: JPM ) , has announced buybacks worth $15 billion through the first quarter of 2013, subject to regulatory approval. Wells Fargo (NYSE: WFC ) raised dividends by an amazing 83%. US Bancorp (NYSE: USB ) increased its annual dividend by 56% and authorized a brand-new 100 million-share repurchase program. Most of the banks were in a rush to increase dividends and gain investors' confidence. But some didn't, while there were a few that couldn't.
Bank of America (NYSE: BAC ) , the second largest U.S. lender, which saw its loan-loss estimates adjusted by the Fed, had its shares soar to their highest level in nearly seven months. The Fed also confirmed that the ailing bank has definitely improved when it comes to strengthening capital. But the bank has chosen not to jump on to the bandwagon and raise dividends, or to go ahead with stock repurchases -- for now. On the other hand, the Fed rejected Citigroup's (NYSE: C ) capital plans and offer to raise dividends, as it failed to make the cut.
Is all well?
The economy is still sluggish, and conditions in Europe aren't great. Most of the banks that passed the test have significant European assets that might turn the delicate balance they've managed. So we aren't completely out of the woods yet. Fellow Fool Ilan Moscovitz thinks the tests were centered on solvency and don't provide any assurance that there won't be another financial crisis.
The point Morgan raised regarding the round of tests worries me, as it's true that every recession is different from the previous one. While this round of stress tests was, well, stressful, it was limited, as it assumed the next recession would be no different from the current one. There are many factors that the Fed misses completely, including the student-loan bubble, rising oil prices, the European debt crisis, and so on. These conditions need to be factored into the equation. Most banks also continue to be significantly levered, and ratios have been aggressively managed using a host of accounting moves.
For a change, offering no dividends works
So while higher dividends and more repurchases are signs of a healthy company, lower equity suggests that banks have less of a cushion if things were to take a turn for the worse again. It's good to see these behemoths perform well under this round of stress tests, but it doesn't tell us much about their operating and growth capabilities in a virtually zero-interest-rate environment.
Is it, then, a wise decision for the Fed to allow banks reduce their capital (in the form of increased buybacks and dividends) in the face of economic uncertainty? What say you? Leave your comments below.
But if these too-big-to-fail behemoths are not for you, don't worry. Fellow Fool Anand Chokkavelu highlights one name that looks like the kind of bank Warren Buffett might have bought in his earlier years in "The Stocks Only the Smartest Investors Are Buying." I invite you to download this special report for free.