When the Federal Reserve announced the results of this year's stress tests on Wednesday, one of the biggest surprises was that three of the nation's leading financial companies came within a hair's breadth of failure.
JPMorgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS) all had to resubmit their capital proposals to the central bank last week in order to get approval to increase their dividends and share buyback programs for the upcoming year.
The purpose of the annual stress tests is to determine whether the nation's biggest banks have enough capital to survive an economic downturn similar to the financial crisis of 2008-2009. The Fed does this by drafting hypothetical economic scenarios and then projecting what would happen to banks' balance sheets under those assumptions.
In its most severe scenario this year, the Fed assumed that unemployment would spike to 10%, stocks would fall by 60%, interest rates would stay low, and housing values would decline by 25%. On top of this, the Fed applied a special test to the six financial firms with the largest trading operations -- namely, JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley.
The primary consequence of the general scenario was large loan losses. According to the Fed's projections, Wells Fargo would have to write off an estimated $56.4 billion in loan losses (or, more specifically, loan loss provisions), JPMorgan Chase's tab came to $55.5 billion, Citigroup's to $50.3 billion, and so on.
The fallout of the trading-specific scenario was large trading and counterparty losses. And it was here where JPMorgan Chase, Goldman Sachs, and Morgan Stanley appear to have run into problems, as the Fed estimated that the three firms would lose an additional $56 billion combined.
The added losses from trading, coupled with the firms' original dividend and share buyback requests, caused certain capital ratios at the three banks to fall below the regulatory minimum at the nadir of the Fed's severely adverse economic scenario. As the central bank explained:
In the supervisory severely adverse scenario, three [bank holding companies] -- Goldman Sachs, JPMorgan Chase, and Morgan Stanley -- were projected to have at least one minimum post-stress capital ratio lower than regulatory minimum levels based on their original planned capital actions. Goldman Sachs fell below the minimum required post-stress tier 1 risk-based and total risk-based capital ratios; JPMorgan Chase fell below the minimum required post-stress tier 1 leverage ratio; and Morgan Stanley fell below the minimum required post-stress tier 1 risk-based and total risk-based capital ratios.
The net result was that, in the week between the first round of this year's stress test (the results of which were announced March 5) and Wednesday, these three banks had to reduce the size of their proposed dividend increases and/or share buyback programs.
This shouldn't be taken to mean that these three banks are necessarily riskier than others. Indeed, JPMorgan Chase and Goldman Sachs have long been two of the best-run firms in the financial industry. Rather, what it means is that the Fed is serious about clamping down on noncore banking activities at the nation's largest lenders.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends Bank of America, Goldman Sachs, and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc, JPMorgan Chase, and Wells Fargo and has the following options: short April 2015 $57 calls on Wells Fargo and short April 2015 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.