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

Page 1 of 2

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.

Page 1 of 2
blog comments powered by Disqus
Insider Monkey Headlines
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 52 percentage points in 24 months Click to see monthly returns in table format!

Lists

The 10 Countries with the Highest Suicide Rates

The 10 Most Technologically Advanced Countries in the World

The 10 Safest Countries in the World to Live in Peace

The 10 Top Selling Smartphones in the World 2014

The 12 Biggest Shopping Centers in the World

The 10 Friendliest Countries in the World

Qihoo 360 Technology Co Ltd (QIHU), Actavis plc (ACT), Yahoo! Inc. (YHOO) Among 20 Long Ideas from Sohn Canada

The 10 Laziest Countries in the World

The 10 Most Polluted Countries in the World

The 10 Most Dangerous Cities in America 2014

The Top 10 Gold Producing Countries in the World

The 10 Tallest Buildings in the World

The 10 Richest Stand Up Comedians in the World

The 10 Fattest Countries in the World

The 5 Best Summer Jobs for Teens

The 10 Most Religious Countries in the World Keeping the Faith

The 10 Most Educated Countries in the World

The 10 Most Popular Cell Phones in the World

The 10 Drunkest Countries in the World

The 10 Most Expensive Private Schools in the World

The 10 Smallest Countries in the World

Walking Dead Season 5 Spoilers You’ll Wish You Didn’t Know

The 10 Poorest Countries in the World

The 10 Greenest Countries in the World

The Top 10 Countries with the Highest Population in the World

The 10 Most Visited Countries in the World

The Top 10 Star Wars Characters in the Iconic Series

The 10 Most Expensive Android Phones in the World

5 Reasons Why The Illuminati Is Real and a Threat to Society

The 6 Scariest Halloween Costumes Ever Screamed At

The 4 Biggest Hedge Fund Managers in the World Today

The 15 Most Densely Populated Countries in the World

The 10 Biggest Tea Drinking Countries in the World

Top 6 Ways to Improve Your Checkout Process and Close Sales

The 5 Most Profitable Online Businesses You Can Start Today

The 20 Most Profitable Hospitals in the US

The 5 Most Profitable Home Businesses to Start

The 7 Teams that Will Win the Stanley Cup in 2015

The Top 10 Most Expensive Digital Cameras to Snap Stunning Shots With

The 10 Highest Quality Fast Food Restaurants In America Today

The 8 Best Halloween Decorating Ideas to Spook Up Your House

10 Marvel Women that Should Get a Movie Right Now

The 20 Best Remixes of Popular Songs that Will Make You Forget the Originals

7 Most Expensive Cities in the World

5 Least Expensive Cities in the World

10 Celebrities Who Believe In Scientology

10 High Margin Food Products to Build a Business Around

The 10 Most Expensive Clothing Stores in the United States to Get Decked Out At

The 5 Biggest Kickstarter Scams That Swindled Backers’ Donations

The 10 Most Expensive Boarding Schools In the World

Subscribe

Enter your email:

Delivered by FeedBurner

X

Thanks! An email with instructions is sent to !

Your email already exists in our database. Click here to go to your subscriptions

Insider Monkey returned 47.6% in its first year! Wondering How?

Download a complete edition of our newsletter for free!