Yesterday, the Federal Reserve released the results from its most recent round of stress tests. For investors in Capital One (COF +0.84%), its performance demonstrated the lender's ability to sustain adequate capital levels in the face of an extreme economic shock. The charts and discussion below examine how the company's capital and earnings held up under the Fed's "severely adverse" economic scenario.
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, Capital One's Tier 1 common capital ratio held up well in light of these assumptions. Starting from 10.7% at the end of last September, it bottomed out at 7.4% over the hypothetical time period extending from the fourth quarter of last year through the end of 2014. While that equates to a 31% decline, the ending figure nevertheless comfortably exceeded the Fed's 5% reference rate. By comparison, the average Tier 1 common capital ratio of the 18 institutions tested fell by a third, down to 7.4% -- almost exactly as Capital One did.
Source: Federal Reserve.
With respect to net income, the regional lender and credit card giant fared even better on a relative basis. Its hypothetical pre-tax loss for the nine-quarter time period came in at $8 billion, beating out the 18-institution average loss of $10.8 billion. The worst performing financial institution in this regard was Bank of America, with a whopping $51.8 billion in estimated losses. Conversely, the Bank of New York Mellon fared the best, with $5.5 billion in positive earnings despite the assumed economic Armageddon.
Source: Federal Reserve.
Breaking this down a bit further, as you can see in the figure above, Capital One's $18.7 billion in pre-provision net revenue was more than consumed by loan loss provisions -- that is, money set aside to cover future losses from soured loans. These accounted for $26.4 billion in losses. Estimated losses from securities added another $300 million.
And digging into the loan losses specifically, it should be no surprise that the lion's share, or 70% of Capital One's hypothetically soured loans derived from its credit card operations. Roughly 20% of the remaining losses were associated with its non-credit card consumer loan portfolio, and the final 10% were related to commercial borrowers.
Source: Federal Reserve.
At the end of the day, the stress tests are meant to do exactly what the name implies: stress you out. And while this year is no exception, investors in Capital One can rest easy thanks to its more-than-abundant capital base. The question now is whether the bank will get regulatory approval to raise its dividend payout. But for the answer to that, we'll have to wait until next Thursday.
