How American Express Dominated the Stress Tests

If you're an investor in American Express (NYSE: AXP  ) , then you have nothing to fear from the Federal Reserve's most recent round of stress tests. Released yesterday, the iconic credit card company emerged from the central bank's gauntlet in markedly better shape than the majority of its financial brethren. In the charts and discussion below, I examine how the company's capital and earnings held up under the Fed's "severely adverse" economic scenario.

American Express passed the tests with flying colors
The purpose of the stress tests is to gauge how the capital bases of the nation's largest financial institutions hold up in the face of economic and financial turmoil. Among other things, the most extreme case assumes that real GDP declines an average of 4% this year, unemployment ratchets up to 12.1% by the second quarter of next year, and that home prices plummet by 20% over the next 24 months.

As you can see in the chart below, American Express' Tier 1 common capital ratio held up remarkably well in light of these assumptions. Starting from 12.7% at the end of last September, it bottomed out at 11.1% over the hypothetical time period from the fourth quarter of last year through the end of 2014. That equates to a 12.6% decline. By comparison, the average Tier 1 common capital ratio of the 18 institutions tested fell by a third, down to 7.4%.

Source: Federal Reserve.

With respect to net income, American Express' hypothetical pre-tax earnings for the nine-quarter time period came in at $800 million. While this may not sound like much, it greatly exceeded the average, which came out to be a $10.8 billion loss. Bank of America led the way down in this regard with a staggering $51.8 billion hypothetical loss. Conversely, the Bank of New York Mellon fared the best, with $5.5 billion in earnings despite the assumed economic Armageddon.

Source: Federal Reserve.

Breaking this down a bit further, as you can see in the figure above, the vast majority of American Express' $15.4 billion in pre-provision net revenue was consumed by loan loss provisions -- that is, money set aside to cover future losses from soured credit card loans. These accounted for $14.2 billion in losses, while "other losses" ate up an additional $400 million.

And digging into the loan losses specifically, it should come as no surprise that American Express' were largely a function of its credit card lending operations, which accounted for 75% of provisions versus the remaining 25% related to commercial and industrial loans.

Source: Federal Reserve.

At the end of the day, the stress tests are meant to do exactly what the name implies: stress you out. At least for investors in American Express, however, there's no need for this, as the company outperformed the majority of its stress-tested peers in terms of both capital erosion and earnings ability.

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