What do CCAR results mean for the biggest US banks?

All 31 of the nation's largest banks passed the first round of stress testing by the Federal Reserve, some with flying colors and others by the skin of their teeth. Second round results, announced this week, brought a few surprises.

The Fool's senior banking specialist John Maxfield shares the Comprehensive Capital Analysis and Review results and what they mean for the likes of powerhouses such as JPMorgan Chase (JPM 2.51%) and Goldman Sachs (GS 0.22%), stress test straggler Citigroup (C 1.41%), and even international players like Deutsche Bank (DB 0.70%) and Santander (SAN).

A full transcript follows the video.

Kristine Harjes: The Fed verdict is in; are U.S. banks braced for the worst? This is Industry Focus.

[INTRO]

Welcome to Industry Focus. I am Kristine Harjes and I've got The Motley Fool's senior banking specialist, John Maxfield, on the line. Hi John, how are you doing today?

John Maxfield: I'm doing great. Thanks a lot Kristine.

Harjes: On last week's episode, we talked about the Fed's stress test.

The first round of tests, as a reminder, examined the ability of the 31 biggest financial institutions overseen by the Fed to withstand a hypothetical downturn of the economy, given their current balance sheets and levels of returning capital to shareholders. Results from that test came out on March 4, and all of the banks passed.

Then there was the second round of tests, which we alluded to last time. They have happened in the week in between; those were the CCAR tests, which stands for Comprehensive Capital Analysis and Review.

That ran the banks through an analysis of a hypothetically severely adverse economic downturn, defined in a whole bunch of different ways. It took into consideration the banks' submitted plans for returning their capital to shareholders.

Basically, it's the moment of truth for whether or not banks will be allowed to proceed with their planned dividend increases and share buyback programs.

I'm thinking, let's start by talking about the banks that had poor performance, and then shift over to those who are celebrating good news. Sound good?

Maxfield: That sounds great.

Harjes: Great. Do you want to kick off? Let's talk first about Deutsche Bank and Santander Holdings.

Maxfield: Deutsche Bank and Santander, this is the first time they had taken part in the annual Federal Reserve-administered stress test.

These are both international banks, so the only portion of these large international conglomerates that was actually tested by the Federal Reserve were their United States-based operations, which are relatively small in the whole scheme of things, when it comes to those banks.

Both of those banks "failed" the stress test this year, and it wasn't for quantitative reasons. That is, in the Federal Reserve's hypothetical severely adverse economic scenario, it wasn't that their capital levels fell too low. It was that the Federal Reserve, in the second step of the stress test, the CCAR step, found that their capital planning processes were deficient.

When these banks were figuring out how to determine how much capital they should distribute to shareholders, or when the economy goes down what would happen to their capital base, the Fed determined that the banks didn't have as good a grasp on making those projections as they should.

Harjes: Do you think that qualitative analysis is just as important as the quantitative verdict?

Maxfield: One could argue, quite frankly, that the qualitative aspect is much more important, because one of the things we know -- and we've seen a lot of studies on this, a lot of conversations in the behavioral finance realm on this -- one of the things we knows is that making concrete projections is always somewhat of a fool's errand, because you just don't know what the future is going to look like.

The actual numbers, you should always be suspect about precise figures that come in the form of projections, so studying the actual process through which those numbers come about is probably actually a better reflection on how a bank will do in a severely adverse economic situation like the Federal Reserve projected in the stress test.

Harjes: That's a really good point. Let's talk about another bank that had orders from the Fed to address certain weaknesses in its capital planning process; those qualitative grounds again. Bank of America (BAC 3.35%), what happened there?

Maxfield: Bank of America was a very similar situation. In the first round of the stress test, which just tested quantitatively whether or not the banks would have enough capital to survive an economic downturn akin to the financial crisis of 2008-09, the Federal Reserve determined that Bank of America would have enough capital to pass that.

But then when the Fed came in a week later, when they released the results of the CCAR step in the analysis last week on the 11th, they determined that just like Deutsche Bank and Santander, Bank of America has problems with its actual capital planning process.

Again, there was a qualitative ... it wasn't a rejection. It was more of a conditional approval, that Bank of America can go forward with its capital plans -- which by the way were relatively small compared to many of the other banks.

They didn't increase their dividend. I think they did have a share repurchase program. If my memory serves me right, it was $4 billion, which is much, much less than JPMorgan Chase, and more specifically Citigroup -- because Citigroup and Bank of America had relatively similar situations in the financial crisis.

Bank of America, they had a relatively small uptick. I think it's probably safe to assume that one of the reasons that they asked for so little increase was probably related to feedback they had gotten from the Federal Reserve earlier on in the process, related to the qualitative aspect of their capital planning process.

Harjes: That seems like the whole point of having this situation happen in two rounds. Is that correct?

Maxfield: Yes, that's exactly right. The first round is just to see what would happen to their capital if their current capital plans don't change. The second round is to see what would happen to their capital if their projected capital returns for 2015, or for the year ahead, were taken into consideration.

Harjes: Great. Let's move on a little bit to talk about some different institutions. Tell me what went on with JPMorgan Chase, Goldman Sachs, and Morgan Stanley (MS 0.44%). It seemed like they were in a similar situation.

Maxfield: Yes. JPMorgan Chase, Morgan Stanley, and Goldman Sachs; this is an interesting group because these are all ... well, let's take Morgan Stanley out of the equation for a second.

When you look at JPMorgan Chase and Goldman Sachs, these are literally two of the best, not only financial companies in the United States, but companies over all. These are just phenomenally run institutions and they have their choice of the top talent in the country in any given year, from the top universities.

So, it was somewhat surprising to see that these guys ... they didn't get rejected, out and out, but in that week between the first round of the stress test and the second round of the stress test, what they had to do was resubmit their plans about how much capital they're going to return to shareholders over the next year.

They had to do that because, in each of those cases, those banks came perilously close to dropping below the regulatory minimum capital threshold, and (unclear) for a variety of capital ratios that the Federal Reserve uses to ascertain whether or not the banks have enough money to absorb a crisis akin to the financial crisis.

They came back in because if they had kept their original capital return proposals for 2015 in place, that would have dipped them below that regulatory minimum, so all three of those banks had to come back in, resubmit lower, less ambitious capital plans, in order to make it past the CCAR step in the analysis.

Now the question is, why did they have problems? The answer to that is, this year the Fed paid particularly close attention to the banks that have large trading and counterparty operations. Those are your traditional -- I guess not "traditional" anymore, after the financial crisis -- but when you think of your investment banking operations, those are the banks that that hit.

Because the Federal Reserve looks so closely at that, they set some much larger potential damages in the event of a crisis than those banks had projected for themselves.

Harjes: Right, and in that special test, just for this specific trade-focused scenario, those three banks -- JPMorgan, Goldman, and Morgan Stanley -- they lost a projected $56 billion, combined, just in loan loss associated with the trading operations test. Super interesting there.

Maxfield: That's right, and you have to keep in mind that that $56 billion, split between those three banks, was on top of ... I don't have the number off the top of my head, but on top of tens of billions of dollars in projected loan losses.

Harjes: JPMorgan, $55 billion alone, there.

Maxfield: Yes, exactly. It was these trading losses at each of these firms that tipped them over, if you will, and made them have to be a little bit less ambitious with how much capital they were going to take off their balance sheet and give to their shareholders.

Harjes: Let's move on to good news! Tell me about Citigroup.

Maxfield: Citigroup is great news! Citigroup was the one major "too big to fail" bank, if you will, left from the financial crisis that hadn't been given approval to increase its dividend.

This is something that has weighed on Citigroup and its executives for a number of years now. In fact, many people think that its rejection to increase its dividend, I think it was three or four years ago, was what led to the ouster of its former CEO, Vikram Pandit.

A lot of people were speculating that its current CEO, Michael Corbat, would either resign or be fired in the event that Citigroup didn't pass the stress test this time. Fortunately, they did pass.

One of the reasons they passed is that over the last year they've spent something like $180 million dedicated to just fixing and updating their capital planning process, in order to pass the Federal Reserve stress test.

If you look at their results in the first round of the stress test, what you see is that they have one of the highest Tier 1 common capital ratios in the industry, even assuming that the economy goes through a dramatic downturn similar to 2008-09.

You think about how far Citi has come from the financial crisis, because it was clearly the worst performing bank in that regard. You can get an idea for how badly managed it was, by just looking at a 10-year stock chart. I think its stock is still down something like 90% from 2006.

The fact that it finally got the go-ahead to increase its dividend and to buy back some shares is certainly a huge relief, for both Citigroup shareholders and for its management team.

Harjes: I'm sure Michael Corbat is finally getting a good night of sleep after all this!

Maxfield: Yes, I'm sure that a lot of those guys had quite a weekend, this past weekend!

Harjes: Definitely! With this approval, Citigroup was approved for a pretty sizable share buyback program, of $7.8 billion. Some have been voicing the opinion that they would rather have seen a bigger dividend increase than such a big buyback program. What's your take on this?

Maxfield: My take on this, first of all, as a general rule, Citigroup has a history of being very, very bad when it comes to returning capital to shareholders. What do I mean by that?

What I mean by that is, if you look at the four or five years before the financial crisis, it bought back something like $40-50 billion worth of its stock, and that just so happened to be about how much they needed to make it through the financial crisis.

They expended all their ammo before the crisis, when they didn't need it, buying back all the stock when it came in, and then diluted their shareholders egregiously during the financial crisis to raise capital -- so they're not very good at these decisions.

However, if you're going to return capital to shareholders and you're an executive with Citigroup, right now definitely the right way to do so is to do it via share buyback as opposed to dividends.

I say that for the simple reason that Citigroup's shares are still trading for a 20% discount to book value. What that means is that Citigroup can come in and pay basically $0.80 on the dollar to buy back all of their shares, which is then immediately accretive to the current owners of Citigroup shares.

The fact that they only increased their dividend by, I think, $0.04 a share; that may be a small increase, but that massive $7.6 or $7.8 billion share buyback should be a big boost to Citigroup shareholders.

Harjes: The other aspect of that is that the Fed looks at these buyback programs more favorably in general, because they're easier to stop. It's not quite as risky a commitment.

Maxfield: That's exactly right. If you have a bank -- or any financial institution, or any company for that matter -- and it cuts its dividend, that communicates very clearly to the shareholders that something is amiss at that bank or at that company.

Share buybacks are totally different. A company can shut off their share buyback program immediately, and quite frankly most people won't even know that they did so until the next quarterly results are filed with the SEC.

It's something that's a lot easier for banks to stop doing, and that's why the Fed likes it, compared to dividends.

Harjes: Something that we see time and time again is that success in investing and financials is really about limiting the downside for when the economy turns for the worse -- which it inevitably will.

Having such a robust look at a hypothetical set of adverse conditions is really important for understanding what's going on with these institutions, as well as what investors can expect going forward.

Of course, no one can predict the future, but the results from the Fed's stress tests allow us to make better informed decisions.

Listeners, if you're looking for follow-up on Citigroup, Bank of America, JPMorgan, or any of the other banks that we mentioned today, make sure to check out our coverage on Fool.com for more analysis from John and our other analysts.

John, thanks so much for your time today. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.