What to Make of the Bank Stress Test News

The Federal Reserve recently announced that all 23 banks subject to the 2021 stress tests passed with flying colors, clearing the way for dividend increases and new buyback plans. Plus, Visa (V -0.59%) is planning to acquire another open banking start-up after its previous attempt to acquire Plaid didn't work out. In this episode of Industry Focus: Financials, host Jason Moser and Fool.com contributor Matt Frankel, CFP, discuss these top stories and more.

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This video was recorded on June 28, 2021.

Jason Moser: It's Monday, June 28th. I'm your host Jason Moser. On this week's financial show, we've got the latest in the round of bank stress tests. Visa is moving past its failed bid for Plaid. JPMorgan is wading deeper into the mortgage market. We'll wrap things up with a couple of stocks to watch. Joining me as always, it's Certified Financial Planner, Mr. Matt Frankel. Matt, how's everything going?

Matt Frankel: I am doing great. It's a sunny hot day in South Carolina. Hopefully it's at least nice where you are.

Moser: Well, it is a sunny, hot day here in Northern Virginia as well. It's summer, it should be sunny and hot. At least we get the pool open. If I understand correctly, Matt, you have a pool now, is that right?

Frankel: Yeah. If it gets much hotter, I might actually broadcast while I'm waiting in the pool.

Moser: I want to be there for that. Give me a little heads up that's coming down and we'll make sure to adjust the show accordingly. Matt, we have a lot of interesting news that came out through the course of last week. Let's go ahead, just get to really what is the lead story I think for the week. You and I both agreed on the latest round of stress tests. I thought this was interesting from a number of different angles, but first and foremost, it appears like all U.S. banks, all big banks here domestically are in pretty good shape now. Given the purpose that this stress has served, I think we can all get behind why they exist. It sounds like all 23 banks here are, according to the Federal Reserve, in pretty good shape if we run into another economic downturn.

Frankel: In a lot of ways, I feel like this was less of a headline than it has been in years past because when you think about it, banks have just gone through an actual stress test.

Moser: True.

Frankel: At the beginning of the COVID pandemic, banks plunged more than most stocks in the market. The reason was, people didn't know if they can handle that stress because the stress test the Fed puts them through was a lot milder in a lot of ways than what the COVID pandemic put them through. For example, the stress test that you just used projected a 55% drop in the stock market, which was a little more than the S&P had. But it projected a peak unemployment rate of 10.8%. In the peak of COVID, we had an unemployment rate that was more than that. Banks were just through with stress tests. It wasn't too surprising, but this was definitely good news that all 23 institutions that were subject to the stress test, remember it's only the biggest ones that had to do it, passed with flying colors. Minimum capital levels would've stayed more than double the regulatory minimums even in that severe downturn. That's pretty impressive. They would collectively lose almost half a trillion dollars, so the stock prices would probably go down if that were to happen. But the banks would survive, and that's really the important part. The reason for these regulations isn't to protect the stockholders, it's to protect the American Republic from bank failures.

Moser: Yeah. I'm glad you made that point because I'm sure there are varying opinions on this too much regulation versus not enough regulation, but it really does seem like this comes from the right place. It does come from a place where it's trying to make sure essentially our entire system doesn't just collapse, given how crucial all of these is going to display in our entire economy. It's very easy, I think, for consumers just to think, oh, that's the bank that charged me those overdraft fees and they're trying to rip me off and they charge me for my account, monthly or whatever. Maybe there's a little bit of a different perception there versus you and I know. Many of us know how these banks make their money in lending. The more money they lend out, the more exposure that is, and you run it into an economic downturn. All of a sudden, that becomes a little bit more connected, it becomes a little bit more apparent and it certainly seems to me like these stress tests, this comes from a good place.

Frankel: A lot of my 20-somethings and early 30s investors might not remember, before these stress tests existed in 2008, 2009, there was a legitimate chance that the financial system would have collapsed.

Moser: I felt that way too, a lot of us, I think.

Frankel: Without the big banking bailout, and they want the need for future bailout to these banks either. It's a really necessary piece of the puzzle. The stress tests are getting a little more flexible overtime, and that's one thing I want to talk about in a minute. But in general, this is a good thing for consumers, for the market in general because the COVID pandemic was tougher on the economy in a lot of ways than the financial crisis was. The financial crisis didn't make the economy grind to a halt. At the time, I was still a grad student, I was working at a restaurant. The restaurants stayed open. The college was still open. People were still going out to eat. It wasn't as devastating of an economic event as the COVID pandemic was. A lot of it was due to the stimulus, that's why the banks handled it so well. But a lot of it has to be attributed to these stress tests and just the increased regulation and increased oversight when it comes to how much capital these banks have to keep, because before, it really wasn't there.

Moser: What do you think is the natural segue with this latest round of tests? The conversation to me, at least for investors, pivots toward something that banks are notorious for investments, dividends and buybacks. A lot of banks have more or less had the freedom to be able to continue those policies, save a few, but it does feel like now, even if it's not something that's necessarily greenlight, something that was already greenlit for many, this problem to me, it seems like this might result in accelerating dividend growth and share repurchases. What's your take there?

Frankel: I think that's an understatement, and I'll tell you why. The stress test methodology in normal years was that if the banks pass the stress test, then they are to submit their capital plans for the Federal Reserve. We want to buy back $10 billion worth of stock. We want to pay X amount of dividends, and then they have to get the regulators stamp of approval on that. That's no longer going to be the case starting with this year. This was supposed to change last year but was put on hold because of the pandemic. Now they have what's called the stress capital buffer framework. This essentially says that as long as a bank keeps a minimum amount of capital prescribed by the Federal Reserve based on its riskiness, it can pay whatever dividends and buy back as many shares as it comfortably wants to.

Moser: That makes sense.

Frankel: This can be a big deal for banks, especially the ones that have really been limited by this, like Wells Fargo, for example. But now banks can do whatever they want. They don't have to get regulatory approval beyond meeting a certain capital buffer for how much they want to buyback. By the way, the reason you haven't seen a whole bunch of announcements about this yet from the individual banks, is the Fed asked for a hold off 'till Monday afternoon, which is today. If you're listening to this on iTunes or whatever, by the time you're hearing this, you might have noticed a bunch of press releases trickling out, and you might have been surprised that the size of them, and that's why because this year banks can really go-forward when it comes to returning capital to shareholders.

Moser: But I feel like next week we may have a great opportunity. We should keep an eye on this over the course of the next 24-hours to see how many of these announcements do come out and the reaction from the market on their respective stocks.

Frankel: For sure, 23 banks, I might need you for the whole hour next weekend.

Moser: Hopefully I'll be able to give you a little bit more time, I think it will be a fun conversation. Definitely something I'm going to be keeping an eye on. Real quick, before we move on to the next story, this is something that banks are, to me, an interesting investment idea from a number of different angles, given the role that they play in the economy. I do like it as I get older. To me, they seem like there would be a nice way to get a little bit of that income diversification in one's portfolio, and feel like they are on better footing now. Hopefully, we don't see the same magnitude of the same type of reaction if something bad happens like we saw back in 2008, 2009, and 2010. By the same token, I also love those small banks. We talk a lot about Ameris Bancorp, for example, on this show here, and a number of others. Where do small banks fit into this discussion here? Of course, they are smaller, they have fewer resources. They're going to be more at risk for something like an economic downturn. But the flip side of that coin is, because they're smaller, because they have fewer resources, perhaps the management teams manage those banks a little bit differently and they don't have that same level of exposure. Is there a trade-off that investors need to be aware of? Is it one versus the other, or is it just they have some big banks, have some small banks, and that makes for a good combo?

Frankel: Well, with small banks, just like any smaller stocks in an industry, you can expect a little more volatility. But it's important to point out that just because the smaller banks don't have to submit to the stress tests doesn't mean they can just do whatever they want. [laughs] It's not like you have heavily regulated risk versus no regulations in the wild west over there in the small bank land. These banks still keep pretty high levels of capital, much more than before the financial crisis. There's a whole lot of different regulations in the individual industries that are adjacent to banking like mortgages that didn't exist before the financial crisis. There are a lot of regulations protecting consumers even when it comes to smaller banks. Having said that, smaller banks have higher growth opportunities. Ameris is one that you follow, I know.

Moser: Live Oak, another one we talked about.

Frankel: Live Oak. I can make the case that either of those will double in size before JPMorgan Chase will. More growth potential, but that also means more execution risk in growing. I would say more volatility, more risk opportunity. I'd say with smaller banks, it's more important to be diversified.

Every time I mention a smaller bank, you name a couple of extra extra, and that's a good thing because you think of it from the basket approach. Whereas like JPMorgan Chase, I would say it's like an all-in. If you want to put 10% of your money in banking, you can put it on JPMorgan Chase and make the case for doing that.

Moser: Or Wells Fargo.

Frankel: Or Bank of America or any of those big ones. They're more like stand-alone financial sector investments. Whereas I wouldn't put 10% of my portfolio in Live Oak even though I love the company. It's because it has a ton of growth potential, but also a ton more volatility than you can expect from some of the bigger names in the space.

Moser: Hey, maybe an idea for a future show then, Matt, and let's just kick this around. A small bank basket. Maybe there's something there. Maybe we come up with a small bank basket and five small banks that we think are worth owning. I don't know. We'll see what the listeners think. They'll hear that suggestion, they'll chime in, and we'll go from there. But what would you think?

Frankel: Yeah, I'd be in for that. I'd actually like to hear some basket ideas. I think we could do a basket series.

Moser: All right, well.

Frankel: I think that'd be cool. I want to hear some basket ideas.

Moser: We'll keep that in mind. Listen, you already lit the fire here. We're going to get some suggestions, I'm sure, and some will be good, some of the less than good, but we'll work with what we got and maybe we'll come up with something.

Frankel: I'm a little more boring. There's only so many REIT baskets you can do.

Moser: Well, we'll see where this conversation takes us as the weeks go on. Matt, in January, it was announced that Visa was not going to be going through with its plan to acquire a financial services company, Plaid. That was primarily due to antitrust concerns. Not a shock. Certainly, it was a risk that we all acknowledged existed. It became a reality. But that didn't stop Visa's management's wheels from turning. Visa just announced they are going to now acquire a Swedish FinTech start-up company called Tink for $2.1 billion. I wonder how you feel about this deal? Given the size of the business, it doesn't seem like there would necessarily be the same antitrust concerns, particularly because I think that the debit connection that existed with Plaid, I don't think that same connection exists with Tink. But nevertheless, $2.1 billion, that's a lot of money. Does this deal make sense?

Frankel: Tink is entirely focused on the European market, which I think will help with regulatory issues as well. It's definitely a replacement for Plaid in Visa's strategy. It's pretty obvious. It's a clear replacement. But having said that, it's a somewhat smaller company, they're paying $2.1 billion. Plaid is valued at something like $13 billion on the private market. But I think Visa was going to acquire it for $billion or $5 billion.

Moser: That deal is something like $5.5 billion.

Frankel: I'd say this is about half the size of the Plaid deal when you look at the price Visa is paying. It's an all cash transaction. Tink is a player in open banking, just like Plaid was, or so I should say.

Moser: Sure.

Frankel: They essentially open up consumers banking information with their permission, usually if the checkbox or something for your information actually is out there securely. But it shares your information with all these lenders, fintech, things like that, to optimize the consumer banking experiences, that goal. Lenders have access to financial information of potential customers that can help them offer them better terms or loans than they would otherwise get. We've talked about similar things in the U.S. market with Upstart. This is one that we've talked about a lot recently. Where they look at a bigger picture of a customer's financial data before making a lending decision. They won't just pull the FICO score and be done with it. Open banking can be applied to situations like that as well.

Moser: Yeah.

Frankel: Big potential applications here. As I mentioned, Tink is and will continue to be for the time being focused on the European market. But really a big part of Visa's strategy to go beyond just its core business of being a payment network.

Moser: Yeah, that's an interesting point you make in Visa trying to get past that core business. I think that's the business that everyone is so familiar with. In simplest terms, Visa is the company that owns that card that's in your wallet. Mastercard is the company that gave you that card that's in your wallet. Now, anybody that follows the payment space, you know that it's far more nuanced than that. There are a number of hands in that cookie jar, so to speak. But given companies like Mastercard and Visa today, they are positioned in the market. The conversation has been one lately of disruption. Smaller players, FinTech, these types of companies disrupt companies like Mastercard and Visa in rendering them "obsolete." Now, I tend to think that's extremely shortsighted. I think that's a very shortsighted view. Part of the reason why I think that is because of just what we're seeing right here. We're seeing with Mastercard, we are seeing with Visa, they're making these little bolt-on acquisitions as they go along in order to build out that strategy and become more things to more people. I think that what some may not think about fully is that when they make an acquisition like this, it just immediately plugs into this massive network.

You look at businesses with massive networks and you look at Facebook, for example, or look at Netflix. Companies where even if you saw a mass exodus of users, it's still at the end of the day isn't going to meaningfully dent the total number of people that are using those networks. When you have that network, it gives you the ability to really do a lot of different things. I look at companies like Visa and Mastercard, to me they seem just as relevant today, and these are the types of acquisitions that should keep them relevant for the foreseeable future. But I don't know, do you think they're going to be regulated out of the market or disrupted out of the market?

Frankel: Yes. Visa's biggest obstacle to growing through acquisition is regulation. We saw that with the Plaid acquisition.

Moser: Of course.

Frankel: Visa could afford to buy Square if it really wanted to.

Moser: Sure.

Frankel: It couldn't get approval to do that.

Moser: I would imagine antitrust concerns would be down there.

Frankel: Visa has cited a $185 trillion global payments market, and that includes things that they are not involved in yet, like person-to-person payments, like business-to-business transfers, things like that. They want to branch out from the core business. Regulation is an obstacle that these businesses are acquiring become infinitely more valuable under Visa's umbrella, like you mentioned. How much more valuable do you think Instagram became when Facebook took it over?

Moser: It's almost impossible to even quantify it, and that was a $1 billion acquisition and now Facebook really is, it's Instagram for all intents and purposes.

Frankel: Right. Or YouTube when Google [Alphabet] acquired it?

Moser: Yeah. Another hit.

Frankel: There's a bunch of examples like that where a business might have seemed like a pretty hefty price tag to pay for a 'start-up'. But how much more valuable does it become under that? Instagram paired with Facebook's $2 billion users or whatever, it becomes Facebook. It's a pretty crazy concept that Visa can acquire a small company and it's instantly creating billions of dollars in value.

Moser: Because of the value of the network.

Frankel: Right. Visa's network is enormous.

Moser: Yes, it is.

Frankel: How universal is Visa accepted for businesses in the U.S. now?

Moser: Yeah. I think that's a very difficult thing that disrupted a powerful and widespread network.

Frankel: I've gone three months at a time without using cash, and [laughs] one of the big reasons is companies like Visa and Mastercard.

Moser: That's right.

Frankel: Take that as you will, but I think it's a step toward diversification. Especially for U.S. consumers I don't know how significant this is going to be, just because it's a European focused business. But it's definitely a step toward diversifying.

Moser: Well, and a good reminder, there's a whole lot going on outside of the U.S. It's a global market opportunity, and so it's always important to remember that. JPMorgan in the news recently, Matt, and it is because of investments they're making in what looks like is described a private label mortgage exchange. This is something where we saw these types of mortgages, ultimately mortgages that are not being backed by Fannie and Freddie. This is something we saw, I think a little bit more in the 2008, 2009, 2010 range. Of course, the financial crisis that occurred then, which was very tied of course to mortgages really impacted the U.S. market. But seems like it's making a little bit of a comeback. I was reading through this story and I thought it was interesting because it seems like one of the reasons why this deal matters and one of the reasons why it could end up, at least to me working out OK for JPMorgan is that things have changed a little bit in the way people own property, what they do with that property. This sharing economy. This Airbnb economy has given folks a new way to utilize real estate, whether it's investment property, vacation homes, or whatnot. There are restrictions essentially that don't allow these mortgages to be sold to entities like Fannie and Freddie. Perhaps there is some opportunity here. What do you think about this move by JPMorgan, does it make sense or is this an unnecessary risk?

Frankel: Yeah, I like this move and it's really important to point out to investors because when you hear alternative mortgages, especially if you were around before the financial crisis. You think of things like those interest-only loans, they used to sell the reverse amortization loans. The zero down loans that they were giving to people with 500 credit scores to buy four and five investment properties. I remember when I was in college I got pre-approved for like a $400,000 mortgage when I was waiting tables. In 2006, 2007, it was absolutely bananas who they were giving credit to and how much money they were willing to lend at that point. This is not that, alternative loans are making a comeback, but for two big reasons. I like that Jason just mentioned vacation and investment properties because there are new rules that govern how many, specifically the percentage of Fannie and Freddie's loans that can be of those two varieties. This was an obstacle when we just bought our second-home, not too long ago. That was a big obstacle to getting a mortgage for it. That Fannie and Freddie can't buy too many of them anymore, so you're seeing a lot of these alternative lenders step in and facilitate those.

No. 2, it's because of all these jumbo loans, as they're called, that you are seeing in the market. Home values are up by 20% or more in a lot of housing markets. The loan amounts are increasingly too big to be bought by Fannie and Freddie, so we're seeing a lot of these jumbo loans that would be part of this exchange that JPMorgan's investing in. There is going to be a growing need for this, especially if housing prices still go through the roof for a little while longer. But also because of these investments in vacation homes, because Fannie and Freddie just can't buy them as much anymore. It's definitely a need, and there needs to be a marketplace for vendors to buy and sell these because I'm sure after you refinance, you've got a letter saying your loan has been sold and here's where you send in your payment due now. I send my mortgage payments to Wells Fargo, that's not who I got the mortgage through.

Moser: No. We send ours now to Truist, I still can't get used to saying that. He was driving me not for this Matt. It looks like it goes to Truist, but we're still having to log into SunTrust. It's totally confusing. Thankfully, I got everything set up, it's just automatically paid, but we're still dealing with two brands here and BB, and T, and SunTrust. They haven't fully brought those together. I know that as a challenging deal. I remember working with Bank of America anytime there's a new bank brought into the system there, it wasn't like it just clicked a button overnight, everything was integrated. The integration takes forever. To your point, it does feel like they are filling a need. At the end of the day economics rule and where there is demand for something, someone's going to come in there with the supply. I certainly understand JPMorgan's angle from that perspective. To me, given what we know about this business, given what we know about who manages it and Jamie Dimon, CEO of the business. I don't look at this as a terribly risky endeavor. Now I could see managers that perhaps are a little bit more short-term focused.

It does seem like it could be a little bit risky making some bad decisions like insurance companies that are more patient and just don't chase business, and over the longer period of time, you will see that through their coverage ratio, it shows that they are efficient operators writing good business. Whereas insurance companies that chase bad business, that pans out of the numbers eventually. I think really I'd be concerned with banks chasing bad business, so to speak in this market. That would probably be something to keep an eye on. I don't know that really worrying about that from JPMorgan's perspective is something that should be top of mind right now though.

Frankel: My guess is they noticed this part of the mortgage business becoming more and more of their business. I guess the jumbo loans especially are really becoming more of a part of the business. This wanted to get ahead of the trend, it's my feeling on why they made this investment. They don't want this to happen without them if this becomes a really big part of the mortgage market. They're getting in on the ground.

Moser: Now, in the jumbo mortgage the minutes of really good point because that partly is a function of the market itself and as valuations rise, those jumbos ceilings need to rise as well or else you're just going to have fewer and fewer people that can even participate in the market to begin with. We've lived up here in northern Virginia for one or plus years or something, and it seems like every year that jumbo rates continue to go up and up and up.

Frankel: Your area is jumbo mortgage central order there.

Moser: It really is. That's just the standard almost as opposed to the exception. Well, Matt, before we take up, we've got two to watch for our listeners this week, a couple of stocks to get on the radar for one reason or another. What is the stock that you'll be watching this week Matt?

Frankel: I am watching a company called Seritage Growth Properties (SRG 0.65%) that we mentioned on the show several times before. They recently got a new CEO, which I'm a big fan of. She recently announced that they are going to sell 40-50 of their roughly 150 properties, so up to about a third of their portfolio is going to be put up for sale. Seritage's business model has always been to gradually sell-off non-core properties in order to reinvest the proceeds in redevelopment. Now it just sounds like they're just trying to get a big stockpile of cash all at once to really super charge their plans. I'm a big fan of this move. I think it sounds scary for it to be selling a third of its properties on the open market. But one, given today's real estate market this is the time to do it. If you have property down low, this is the time. But I think they're going to get some good valuations forums. I think they will have a lot of cash and just to see them finally really accelerate their development because they're realizing the slow and steady model that the company was founded on isn't really going to work.

Moser: Not necessarily technically financials related, but it's tied to real estate in a way, Matt. I'm keeping an eye on Wayfair (W -1.94%). This is a company I own shares in and as I've recommended in one of the services that I lead here at the Fool and just interesting conference they participated in last week, the Jefferies Digital Consumer Conference. There were just some numbers that stood out to me that reinforce why I don't want to sell my shares anytime soon. They talk about their market opportunity, the total available market they're addressing between Europe and North America at $840 billion with about 50-50 split there in both regions. I think that total addressable market, total available market, that doesn't necessarily mean they're chasing that entire pie. You want to focus maybe a little bit more on the addressable market regardless, $840 billion, even if you cut that in half. That's a lot of money and so a large market opportunity worth paying attention to, and then they had another data point here I thought was pretty fascinating. American Savings Accounts had gone from $800 billion pre-pandemic levels to over three trillion dollars post-pandemic with all of the stimulus and assistance that folks have been receiving over the past year, so certainly feels like there may be some pent-up demand out there. It also feels like Wayfair is going to be one of those networks that really helps provide for what folks want. You and I know that shopping for the home is a never ending endeavor, Matt. It never stops. I think Wayfair is one worth keeping an eye on. But Matt, I think that's going to do it for us this week. I really appreciate your jump in here as always, great stuff on the stress tests and we'll keep an eye on what those banks are doing later on during the week to see if there's any story we need to pick back up on next Monday.

Frankel: Always fun to talk to you.

Moser: Folks, remember you can always reach out to us on Twitter @MFIndustryFocus or you can drop us an email at [email protected]. As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against. Don't buy or sell stocks based solely on what you hear. Thanks as always to Tim Sparks for putting the show together for us. For Matt Frankel, I'm Jason Moser. Thanks for listening and we'll see you next week.