As the contagion in Europe continues to march ahead, the market is trying to better understand the Fed’s announcement yesterday regarding seemingly new stress tests for U.S. banks. Many posit that the Fed is worried about the health of the U.S. banking system in light of the issues in Europe. Some feel that it is an attempt to show the market that the U.S. banks are actually very healthy in light of the potential economic hazards.

 

The truth here might be a bit more innocent than many think. The stress tests are actually part of the requirements of Dodd Frank. They are not new and this is actually the third set that will have been routinely done. Granted, the criteria of these tests are tough, but considering the current environment, may be warranted. The point of it is to gauge our bank’s ability to show they have sufficient capital to survive a major downturn in the economy. The results of these tests will be made public.

 

There is no passing grade here. There is no danger of failing a test here. The tests are being administered to understand the bank’s internal capital levels and their plan to address any shortfalls that could exist in the economic downturn assumption.

 

Our take here is that the tests will actually show just how healthy theU.S.banking system is even under such a draconian scenario. As banking analyst Dick Bove pointed out yesterday in a Bloomberg interview, the U.S. bank industry has enjoyed 9 quarters of higher earnings and lower credit losses since the bottom of the economy in 2009. Our banks have more capital than at any time in history and have had their books dissected and granularly examined by numerous analysts and regulators. Bove points out that the stories being circulated in the press about the banks are not only inaccurate, but close to out right lies, in his opinion. If he is right, and we think he is, the result of these stress tests will actually be good for the banks as it will show in detail that the banking system in the U.S. is most likely the strongest on the globe.

 

Our better outlook for the banking industry is truly a lonely place to be at this time. It is not the first time that we find little company with our contrarian position. We have received superior returns on financial bonds and preferred over the last three years and still feel strongly that these issues continue to offer above average returns in light of the actual risks involved. We think the close scrutiny being paid to their balance sheets are a positive for their credit, not a negative.

 

What will happen with European banks? It seems that they must first address the sovereign debt issues which will probably come sooner than later. We believe that ultimately the European Central Bank (ECB) will become the lender of last resort and that the Euro will be devalued as a means to deal with their debt pressure. It is our position that the banks in Europe will be saved much in the same way as the banks were dealt with in the U.S. Even though we hear much loathing in the press about the banks by governments, we believe that in the end the banks will be successfully recapitalized as needed. We believe the pain level will rise to a point, making the tough decisions palpable and provide for the backstops that are needed. Remember the criticism that the U.S. received from these same European leaders over us allowing Lehman to collapse? In the end, we think Europe will act in their best interest as painful as it might be.

 

It is critical to remember that banks are like utilities when it comes to fixing an economy, in our opinion. Economies cannot exist without healthy banks. Banks can only exist in an environment of trust and confidence which is lacking in today’s markets. We feel the Fed’s actions should enhance the confidence factor and make the environment for banks and their profits actually better rather than worse. We think these events provide for a very rare opportunity for investors that possess the stomach to see past the blood in the streets!

 

 

 

(c) Advisors Asset Management

www.aam.us.com