by Bryan Perry

June 30, 2020

The stress tests conducted on America’s 35 largest banks within the Fed’s sphere of influence resulted in some of what I would call “wishy washy” actions, considering the latest resurgence of the pandemic and the potential economic implications it presents. The purpose of conducting these annual stress tests is to determine how bad bank losses could get – and also to ensure that banks have enough loss-absorbing capital to avoid systemic distress and keep lending to businesses and consumers.

Last Thursday, the Fed voted to require large banks to preserve capital by suspending share repurchases and capping dividend payments in the third quarter. In a 4-to-1 vote, the Fed will tie the distribution of dividends to a formula based on recent income. Second-quarter earnings reporting season is about to get under way and most big banks will be posting their results during the week of July 13-17. So far, there has been little transparency as to how many businesses and people have fallen behind on their obligations.

The Fed’s formula sets third-quarter dividends at a level equal to average net income over the past four quarters. By the Fed’s calculation, some banks may have to cut their dividends. A senior Fed official said that this could be “binding” for some banks. Fed Governor Lael Brainard was the sole dissenter in the 4-1 vote. In her dissent, she said: “I do not support giving the green light for large banks to deplete capital,” arguing instead for a blanket suspension of dividends.

The Fed’s stress test revealed the limitations of the current regulatory regime and its need to tighten their criteria – and soon. The tests’ original worst-case scenarios, devised in February, before the coronavirus crisis emerged, included shocks like a 10% jobless rate, woefully behind the current unemployment rate.

To compensate for a more real-time measure of financial resilience, last week’s stress tests stated that regulators performed a separate “sensitivity analysis” that featured harsher scenarios. In doing so, they erred by not disclosing bank-specific loss estimates, citing the “limitations” and “considerable uncertainty” created by the pandemic. That’s Fedspeak for “We didn’t want to rattle the markets.”

In today’s regulatory environment, the stress tests rely on regulatory capital measures that are imprecise when the ground has suddenly shifted under the economy. Such measures are often at odds with market-based measures that reveal more about a bank’s health. There’s a big difference between the two.

What’s a “market-based” measure? In avionics, market-based measures would be like the instruments designed to address the “climate impact” of aviation, meaning measures beyond normal operational and technological measures. It’s a set of measures to reflect radical change outside of conventional tools.

Instrument Flight

To say there is a “climate impact” on normal banking conditions from COVID-19 is an understatement.

This latest round of stress tests fell short of laying out the climate impact of internal banking operations – specifically, hard and detailed data on bad loans. Instead, banks have been steadily raising dividends and buying back record amounts of stock in the first quarter, and in some instances during the second quarter while jawboning about how well things are going in the midst of record layoffs and shuttered businesses.

This lack of transparency will not “bolster public confidence,” as Fed Vice Chairman for Supervision Randal Quarles expects. On the contrary, it is already undermining trust, leading some observers to speculate that any potential losses must be severe if they cannot be made public.

While the biggest banks might come through a second wave of the coronavirus intact, scores of regional or smaller banks run the risk of being undercapitalized in the coming months for not having taken more aggressive measures to preserve their capital.

The Fed, despite all its good intentions to produce optimism in the credit markets and with investors, may have underestimated the amount of underperforming assets early in the pandemic, which triggered their aggressive fiscal stimulus actions during the past several weeks. While it is very difficult to predict the scale and scope of something like COVID-19, it may show in hindsight about a month from now that the Fed should have restricted all dividends and stock buy-backs from the beginning, back in late March.

According to the Fitch credit rating service: “Before the coronavirus pandemic, the delinquency rate had been steadily falling, and stood at just 1.31 percent in March. Now it’s expected to reach as high as 8.75 percent by the end of September — approaching its peak of 9.01 percent recorded in July 2011.”

Fitch’s delinquency projections don’t include loans in “forbearance,” as many borrowers frantically seek to make arrangements with their lenders, while multi-family borrowers with federally-backed mortgages can receive forbearance from Fannie Mae and Freddie Mac as part of their federal stimulus package.

Unfortunately, investors will have to wait for earnings season to reveal just how good or bad business conditions are within the banking sector. But the Fed’s actions last week suggest they aren’t liking what they are seeing. That’s why those tempting 4% to 8% dividend yields regularly thrown off by many of the leading mega and regional bank stocks might not be solid and may best be avoided for the time being.

Following a powerful rally from the middle of May through early June, most of the banking stocks have retreated to levels that are just above their March lows, sorely lagging the broader stock market.

Regional BankingETF

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

There are plenty of other places to go in the stock market for dividends yielding 3% to 5% that are “good money” now and for the foreseeable future. Buying bank stocks that are being deeply discounted right in front of earnings season is, in my view, one trade to pass on. If the charts don’t lie, then the chart of the SPDR S&P Regional Banking ETF (KRE) should raise a red flag for all those thinking of initiating or adding to positions in what poses to be a very challenging reporting season.

All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.

Please see important disclosures below.

Also In This Issue

Global Mail by Ivan Martchev
My Real-Time COVID Indicator is Flashing Red

Sector Spotlight by Jason Bodner
Go with the Flow (Newton’s 3rd Law of Motion)

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Read Past Issues Here

About The Author

Bryan Perry

Bryan Perry

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry

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