The Federal Reserve conducted a series of stress tests on several major American banks and bank holding companies earlier this week, and most of the banks passed with flying colors. J.P. Morgan Chase promptly announced a $15 billion stock buyback program, Morgan Stanley said it was going to go ahead and buy up an additional 14 percent of Morgan Stanley Smith Barney, and US Bancorp raised its dividend by a whopping 56 percent. Some banks did get some bad news, but after a 2011 in which the financial sector was one of the weakest areas of the market, this week's results were good news indeed for the nation's beleaguered banks. What we may have seen this week was America's financial sector turning a long-awaited corner.
There's no doubt that in an otherwise flat year for stocks, 2011 was uniquely miserable for the financial sector. In the S&P 500, financials were one of only two sectors that lost ground on the year (materials was the other), dropping by more than 17 percent. The single biggest loser among the S&P's 500 stocks was Bank of America, which lost 58 percent of its value. Mutual funds that focused on financials were also hit hard: ProFunds' Financials UltraSector dropped 24 percent, while Schwab's Financial Services Fund dropped 14 percent.
What caused the financial sector to underperform the rest of the market so badly? With interest rates at historically low levels and lending standards remaining tightened, banks are still struggling to make profits. The precarious situation in Europe has also limited the larger banks that make much of their money overseas.
A closer look
What the stress tests were designed to reveal was whether the banks were strong enough to withstand another financial meltdown. Basically, the regulators simulated another financial crisis, and noted the amount of capital the banks would then have on hand. The tests offered up a scenario in which the nation had to endure an unemployment rate of 13 percent, a 21 percent decline in housing prices and a 50 percent drop in equity prices. The idea is that banks should still have enough money to lend businesses in that kind of an economic downturn, so we don't suffer through the kind of credit freeze that exacerbated the last recession.
It turns out that the Federal Reserve's previous round of stress tests helped the banks get through this one. As a result of the earlier tests, lenders were asked to raise an additional $75 billion in capital, while no funds had to be raised after the most recent round. All told, the regulators found that banks had increased their Tier 1 common capital — reserves kept on hand in order to absorb losses — by 81 percent. Of the 19 bank holding companies involved in the stress tests, 15 passed. The four that didn't were SunTrust Banks, MetLife, Citigroup, and Ally Financial.
