Banks: This Week's Stress Test and More

Banks are an integral component of our economy and financial system making their health a concern to Wall Street and Main Street alike. Following the Financial Crisis more than a decade ago, the Federal Reserve now subjects banks to periodic stress test, or what-if scenarios, to see how banks would be expected to perform under a variety of adverse conditions.

$700 billion

This week the Fed released its findings of its most recent stress test designed to specifically study the effects of a possible prolonged economic downturn due to the coronavirus pandemic. In their worst-case scenario, assuming unemployment peaks at -15.6% and GDP declines by -13.8% peak to trough, the 33 largest banks could have loan losses of $700 billion. In an effort to keep banks healthy, the Fed has now capped dividends payable to shareholders and ordered them to suspend share buybacks.

$156 Billion

As of the end of the first quarter 2020, 26 of the 33 banks in the stress test (data is not readily available for the other 7) had loan loss provisions totaling $156 billion. Banks have reacted to the pandemic’s risk as this total loss reserve is up an average of 77% from the prior quarter. Regardless, if the Fed’s worst-case scenario occurs, banks will incur more than $500 billion of additional losses.

This Crisis Compared to the 2008 Financial Crisis

Banks clearly entered our current crisis in far better financial condition than they were in prior to the 2008 financial crisis. A key metric for banks is their loans to deposits ratio. The fewer loans that banks have outstanding relative to their deposits, the lower the risk to the bank. As the accompanying graph shows, the average loan to deposit ratio for the 4 largest banks (J.P. Morgan, Bank of America, Citigroup, and Wells Fargo) has been trending lower for the past decade.

From an investor’s perspective, banks were among the worst performing sectors during the financial crisis more than a decade ago, as illustrated in the below graph in blue, with the average bank stock falling more than -80%. They recovered from those 2009 lows but never reached all-time highs and are now off more than -36% in 2020.

Although the economy has a meaningful impact on banks’ success, I’ve included the Fed Funds Rate, the target interest rates set by the Federal Reserve, on the below graph in orange. You can see this seems to have a direct impact on the performance of bank stocks as banks tend to be more profitable in higher interest rate environments and less profitable when rates are low as they are now and are expected to be for some time.

This Week's Performance Highlights

Source: www.YCharts.com

Investors’ fears of a second wave of COVID-19 in the U.S. as many states allow the economy to reopen drove stock prices lower with two of the five days experiencing relatively steep declines. Economic data generally showing improvements but not as much as had been hoped for by economists furthered fears that the recovery may take quite some time. These fears lead investors to the safe havens of gold and bonds as those assets were the only ones higher for the week.

Economic Indicators

New home sales for May came in stronger than expected at an annualized rate of 676,000 which was up +16.6% from the prior months number. These number can be subject to significant revisions as we saw for the April number being revised down to 580,000 from an originally reported 623,000. The two areas of the country hardest hit be COVID-19, the Northeast and the West, saw the biggest surges up +45.5% and +29.0% respectively. Helping fuel this strength is record low mortgage rates making homes more affordable for buyers.

Existing home sales also came in better than expected at 3.91 million but this was down from 4.33 million the month before. One reason for the drop in existing home sales while new home sales increased is a difference in the reporting method. New home sales are reported when the contract is signed while existing home sales are counted when sales are closed. Therefore, the May existing home sales numbers really reflect more of what was happening in March and April when those contracts were being signed. Expectations are that these numbers will improve next month.

Weekly initial jobless claims, once an almost ignored report, has become one of the most closely followed since the start of the pandemic. This week’s report showed another drop in claims to 1.48 million but this was higher than economists had expected and suggests improvements in this number are slowing. When including claims made through a temporary federal program the number came in at 2.19 million which was down just fractionally from the week before.

Consumer spending surged in may up +8.2%, a massive rebound from the prior month’s decline of -12.6%, but fell short of economists’ expectations of a gain of +9.9%. This was generally considered a good sign that consumers are both willing and able to spend but spending remains -12% down from February pre-pandemic.

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