As Wall Street pays homage to the daily helping of economic data of choice, we think the results of the Federal Reserve’s “stress tests” (be smart: computer programs that run scenarios to see what in the economy would cause a megabank to go under) are intriguing on a multitude of levels.
There is the fact that most banks are still not paying dividends to shareholders some three and a half years after investment bank Lehman Brothers filed for bankruptcy. Then there is this notion that to feed the dividend-seeking appetite of shareholders (which include bank executives themselves), banks will take all sorts of financial risks once again, basically finding loopholes in new government regulations (hey, I-bankers are a smart bunch).
Or how about the crowd that believes banks shouldn’t be allowed to shell out dividends at all, since taxpayers will be bearing the brunt of saving (sound smart: “bailout”) the financial system in late 2008 for years into the future?
Anything involving how banks operate and what causes their stocks to rise and fall tends to be complex. As simple as this may sound, banks are a complete different beast to invest in than Walmart, given the layers of government making sure they are operating on the up and up. That said, there are basic concepts and terms to decode to get you through a party discussion on an industry that always steals the front pages of newspapers. At the very least, you deserve to understand the decoded real deal on a JPMorgan before heading to a local branch to make a deposit.
Stress test: People hate going for a stress test; it causes them to take a day off from work to address a problem that may not even exist. Same goes for banks, except the doctor that administers its exams is their personal physician, the Federal Reserve. Under a bank stress test, hardcore number crunchers plug data into a computer model to tell if one not so little bank, should the economy stumble into a period of a 13% unemployment rate, risks sending other banks to the cleaners. How that bank would fail its stress test is if owns too many dodgy loans (example: loans of homeowners with poor credit ratings and late payments) and does not have enough money (sound smart: “capital”; “reserves”) to cover potential losses. Fail a stress test, wave goodbye to paying dividends and buying bank stock, Mr. CEO.
Give back too much: A person close to our team once said “less is more.” In the case of banks, that could be quite true. If a bank passes the latest stress test and tries to enrich its starving shareholders quickly, it runs the risk of not having enough money on hand should the economy head south again. There is also the risk of triggering a public backlash.
If a real life MD doesn’t disclose your health records, why should the Federal Reserve disclose a bank’s?: Let’s say XYZ bank is found to be “inadequately capitalized,” which is the high class way of saying, “Hey, bro, you failed your stress test.” Now, the entire world of investors, aka the “market,” is aware that your bank is sickly; in turn they opt to short your stock or if already a shareholder, dump it altogether. By doing this, it would set in motion additional problems. Sometimes “less is more.”
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