Manna from the Fed for Banks

03/14/2012 11:12 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

The stress tests pondered the worst-case economic scenario so that investors could focus on the much more probable and happier alternative, writes senior editor Igor Greenwald.

A week after the market’s Superbad Tuesday, we got its polar opposite. The Dow decisively cleared 13,000 while the Nasdaq soared past 3,000—luxury it hasn’t sniffed in 11 years.

The rush to capitalize on last week’s fleeting discount suggests we may not revisit those milestones until Israel bombs Iran, Europe needs to bail out another austerity victim, or a computer program somewhere judges that enough fun has been had.

Until then, the performance chase will be on among the many small and large investors playing catch-up. Credit the Federal Reserve, which has already asked, "What’s the worst that could happen?" so we won’t have to.

In the alternative reality of the banking stress tests recently conducted by the Fed, unemployment hits 13%, stocks lose half of their value, and housing craters another 20%. And while everyone understands that proud financial titans would be hiding under the Fed’s skirts again in this dystopian future, at least they wouldn’t regret the dividends and buybacks they’re now announcing.

By gaming the worst case, and then letting most banks boost investor returns, the Fed is really inviting us to consider a sunnier alternative.

Say it’s early 2014 and unemployment is at 7.5%. Housing prices are rising alongside longer-term yields. And yet the Fed has stuck to its pledge of exceptionally low short-term rates, music to the ears of banks minting profits from the wider net interest margin.

I don’t care whether JPMorgan (JPM) jumped the gun on the Fed in announcing its 20% dividend hike and $15 billion share buyback. I don’t care that fears of market leaks caused the central bank to rush its stress-test disclosures by two days.

I care that Morgan’s dividend yield is now around 2.7%, while its estimated 2012 price-to-earnings ratio is nine. I care that the profits will very likely balloon beyond current estimates if the rate spread continues to widen.

Returning money to investors has just been sanctified by the Fed as the ultimate gauge of a bank’s health. And while more than a third of JPMorgan’s big buyback will be spent on offsetting stock options issued as executive compensation, 100% of the 83% dividend hike unveiled yesterday by Wells Fargo (WFC) will be lavished on shareholders.

Stuck in the penalty box today is Citigroup (C), its pride and share price hurt by the Fed’s unwillingness to let it share the wealth alongside better-heeled rivals.

Citigroup’s proposed payouts would have left its capital ratio a hair short of the Fed’s required minimum under the worst-case scenario. So the bank will have to lower its sights a bit when it reapplies…and in the meantime, it’s been left looking less than hale.

But the truth is that Citigroup is closer to JPMorgan and Wells Fargo than to Bank of America (BAC), which didn’t even bother asking the Fed to increase its payout. BAC’s share-price pop today while Citi falls is based entirely on appearances, rather than merit.

Meanwhile, the richer new dividends on offer at JPMorgan and its kin continue to trail the 3.1% dividend yield of my hometown bank. It too stands to benefit from a wider net interest margin. And it’s eating Bank of America’s lunch a lot more efficiently than the big boys can.

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