Citigroup Inc. (C), JPMorgan Chase & Co. (JPM): Forget the Stress Test When Buying Banks

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The Federal Reserve recently released the results of its annual stress test, officially known as the Comprehensive Capital Analysis and Review (CCAR). The CCAR assesses the adequacy of a bank’s capital, generally the amount of equity and long-term borrowing available to absorb bank losses. The idea is that strong capital levels help ensure that banks have the ability to meet their financial obligations in times of economic difficulty. But does capital level really matter?

Citigroup Inc. (NYSE:C)

Capital level does not determine shareholder risk

The major risk to bank shareholders is the possibility of insolvency. It is believed that U.S. banks are less likely to go insolvent today because of their beefed up capital structures. The Fed likes to note that the banks have substantially increased capital since the first CCAR in 2009. While it is true banks have more capital, whether it helps protect shareholders during a financial crisis is debatable.

Only months before the financial meltdown in 2008, major financial institutions looked to have roughly the same amount of booked capital relative to assets as leading firms do now. One example is Lehman Brothers, whose shareholders were wiped out in a calamitous September 2008 bankruptcy. They reported about $26 billion in equity capital, and $128 billion of long-term debt in May 2008. This equaled about 24% of their total assets of $639 billion. This capital coverage can be compared to the current position of investment bank Goldman Sachs Group, Inc. (NYSE:GS). Goldman reported around $76 billion in equity and $167 billion in long-term debt for December 2012, or roughly 26% of its $939 billion in assets.

Another case is Citigroup Inc. (NYSE:C), whose stockholders lost roughly 40% from mid-2007 through its recent stock price resurgence. In June 2008, the company reported equity capital of $136 billion and long-term debt of around $418 billion, or roughly 26% of its $2.1 trillion in assets. In December 2012, they showed equity capital of $191 billion and long-term debt of around $239 billion, or roughly 23% of its asset holdings of $1.9 trillion.

Though bank capital has been strengthened, it can be argued that the amounts still do little to protect shareholders against serious financial difficulty. So if capital levels aren’t a critical factor, what is?

Asset diversification matters more

Banks typically go bust when the assets they hold are perceived to be worth noticeably less than their stated value. If a bank’s asset base loses as little as 10% of value on average, shareholder peril rises meaningfully. So banks, as with individual investors, are at less risk when holding a well-diversified portfolio of assets. These portfolios can absorb even large losses from one area without critically damaging the entire business. It usually takes the rare combination of poor asset diversification and a severe economic contraction to put a large bank’s solvency at risk.

Citigroup Inc. (NYSE:C) is a good example of the risk in not being sufficiently diversified. In December 2007, the firm had roughly $311 billion of assets in booked real estate related lending and about $652 billion in off-balance sheet mortgage related investments. This concentration, representing over 30% of total reported assets, in combination with a weakened economy, spelled disaster.

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