FORTUNE -- The Federal Reserve's annual stress tests turned out to be more unpredictable, and less favorable for the banks, than predicted. That's good. Economic downturns are unpredictable, so the test should be too. Not that bank investors liked it. Even the shares of banks that passed the Fed's tests dropped on Thursday.
That's a reversal. In the past year, shares of financial firms have risen 26%, significantly more than the market as a whole. Much of that rise recently was based on the belief that banks would emerge from the stress tests with the okay from the Fed to return gobs of money to shareholders in the form of higher dividends and more share buybacks. Billionaire investor Warren Buffett has said that he finds the obsession with dividends and buybacks odd. Investors can get their money back whenever they want. All they have to do is sell.
But for the banks, not quite six years after the financial crisis, the ability to return capital to shareholders, rather than needing to hang onto it to protect their butts, was supposed to be another key sign that the nation's financial firms were safe investments again. Analysts predicted that the 30 largest banks would return a collective $75 billion to shareholders in the next year.
Instead, the stress test once again pointed out that the banks still aren't as healthy as some think. Keefe Bruyette & Woods, an investment bank that specializes in following financial firms, called the results of the test "below expectations."
The Fed approved just $55 billion in payouts. A good chunk of the miss was Citigroup (C), which was expected to hand out a little over $8 billion in dividends and buybacks. But Citi had its plan rejected. Two other banks, Bank of America (BAC) and Goldman Sachs (GS), only passed the Fed's test after agreeing to cut back what they would pay out to shareholders. Even JPMorgan Chase (JPM), which passed both the first and the second parts of the stress test, ended up announcing it would devote nearly a billion less to dividends and share buybacks than most expected.
The Fed also predicted that the banks' legal troubles were far from over. As part of the stress tests, the Fed estimated that the nation's largest banks could pay another $150 billion covering legal fees and buying back soured mortgages over the next two years.
Then there are interest rates, which are likely to continue to rise in the next year. Higher interest rates could eventually be good news for the banks, but many predict initially they will cause trouble. Already, higher rates have significantly cut mortgage refinancing activity, which has been a big money maker for the banks in the past two years. Loan growth in general has remained slow. What's more, the Volcker Rule, which restricts the banks' trading operations, and other post-financial crisis regulations will officially go into effect later this year. That might further pinch profits.
At the same time, investors seem to be pricing a lot of growth into banks stocks. The shares of the nation's six largest banks have an average price-to-earnings of 15. Those same banks have $6.7 trillion in assets on which they earned an average return of 1.2% last year, or around $80 billion. To get to $92 billion, or 15% more, banks would have to get their return up to 1.4%, higher than it was before the financial crisis. The other option is that banks would have to do a lot more lending. Given the headwinds neither higher profitability nor more lending looks all that likely. In fact, you don't have to construct a stressful scenario for banks to disappoint investors in the next year. Analysts only expect earnings at the six biggest banks to reach $82 billion in 2014.
Bank stocks have been on a roll for a while. They may face a climb from here.
Regulators have grown increasingly concerned about banks' interest rate risk.
FORTUNE -- The Federal Reserve may not be satisfied with some of the results of the annual bank stress tests.
The first indication of how the banks did on those tests is set to be released on Thursday, March 20. It has been widely anticipated that all the major banks will pass.
But a source who is involved in the stress-testing process says MOREStephen Gandel, senior editor - Mar 17, 2014 5:00 AM ET
The Federal Reserve sheds some light on why Goldman and JPMorgan got a conditional pass on this year's stress tests, but the 41-page report is overkill.
FORTUNE -- The Federal Reserve won't rest until the nation's biggest banks are 100% safe, which means, basically, the Fed won't rest.
On Monday, the Fed released a report assessing how well the banks have done in the past year or so planning for another financial MOREStephen Gandel, senior editor - Aug 20, 2013 5:00 AM ET
Bank examination may understate the risk of a huge and growing financial product.
FORTUNE -- In the past year or so, bank executives have taken to referring to their balance sheets as fortresses. It could be a drinking game.
The phrase is supposed to signify how banks are better protected against loan and trading losses since the financial crisis. Later Thursday we'll get a chance to see just how strong the banks' MOREStephen Gandel, senior editor - Mar 7, 2013 7:44 AM ET
Banks could lose tens of billions of dollars if the bond market turns south.
FORTUNE -- In the past year or so, banks, looking for safety and some yield, have stashed an increasing amount of their cash in the bond market, much of it in U.S. Treasuries. If rates were to rise quickly, that could cause huge losses at the banks, and potentially a credit crunch that would rival the financial MOREStephen Gandel, senior editor - Nov 19, 2012 5:00 AM ET
UPDATE, March 27
For two banks that have yet to repay government bailout funds, the Federal Reserve's stress test was easier than for rivals.
FORTUNE -- The Federal Reserve appears to have class favorites.
Analysts say two banks, Regions Financial (RF) and Zions Bancorp. (ZION), received better grades in last week's stress tests than they deserved. One possible reason: Regions and Zions have yet to repay the bailout money they got from the MOREStephen Gandel, senior editor - Mar 21, 2012 5:00 AM ET
Fed says 15 of the nation's 19 largest financial firms are ready for the next recession. Citigroup and others could need more capital.
FORTUNE -- The Federal Reserve said a majority of the nation's largest banks would be able to weather another deep recession. Four banks, though, have more work to do.
In the stress test results it released on Tuesday afternoon, the Fed said that 15 of the nation's 19 largest MOREStephen Gandel, senior editor - Mar 13, 2012 4:57 PM ET
European regulators said 8 banks will need 2.5 billion euros ($3.5 billion) to survive a serious downturn, and that 16 other lenders passed but should raise more money.
Of the failing banks -- those whose so-called core capital fell below 5% -- five are from Spain, two from Greece* and one from Austria, according to results released by euro area banking watchdogs. Of those that passed but could stand to bulk up, with core capital of 5%-6%, nearly MOREColin Barr - Jul 15, 2011 12:06 PM ET
Tim Geithner will get his European stress tests.
Three weeks after the Treasury secretary paid them a visit, European leaders are uniting behind plans to publicly report on the strength of big euro zone banks. European Union officials are close to a deal, the Financial Times reports.
The big push is coming from Spain, which has been taking a beating in the financial markets and would like to make it stop. Shares MOREColin Barr - Jun 17, 2010 12:30 PM ET
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