The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed by Congress and signed by President Obama into law in July 2010, contains a number of requirements on both public companies and on banks. For instance, all public companies must include a shareholder vote on executive compensation, at a schedule decided by the shareholders (between every one and three years). Dodd-Frank also requires that the 20 largest banks in the U.S. be subjected to an annual “stress test” to determine whether they would be able to handle another severe economic downturn, as was experienced just a few years ago. Having seen the published results, Ally feels that the testsare not an accurate characterization of its health.
The bottom line is that 19 of the 20 banks passed every test, except for one. Ally, formerly known as GMAC, beset by severe losses in its ResCap residential-mortgage subsidiary (which itself is in the midst of bankruptcy proceedings, though Ally the parent company is not) had a Tier 1 capital ratio far below the 5% requirement, coming in at just 1.5% under an economic-crisis scenario. (Of note, Ally claimed a preliminary Tier 1 capital ratio of 13.1% in its 2012 financial results press release.)
Ally’s big-bank peers (known as those banks that are “too big to fail,” because of the market’s underlying assumption that the government would step in to rescue them again if the economy took another nose dive before allowing them to fail and shock the financial system again, a la Bear Stearns in 2008) weren’t necessarily interested in the results for the same reasons that Ally was. Instead, the other banks for the most part want to undertake share buybacks and increase their dividends to reward shareholders for mediocre returns over the past few years.
So what the heck is Tier 1 capital anyway? It’s the ratio of the bank’s core equity capital to its total risk-weighted assets. In plain English, (and thanks to Wikipedia),
…assume a bank with $2 of equity receives a client deposit of $10 and lends out all $10. Assuming that the loan, now a $10 asset on the bank’s balance sheet, carries a risk weighting of 90%, the bank now holds risk-weighted assets of $9 ($10*90%). Using the original equity of $2, the bank’s Tier 1 ratio is calculated to be $2/$9 or 22%.
In a nutshell, a low Tier 1 capital ratio for Ally means that not the company may not have enough reserves on its balance sheet to weather another downturn like we saw a few years ago. Ally clearly didn’t back in the GMAC days, since the company was required to accept $17 billion in bailout money from TARP to prop up its bad loan portfolio during the Great Recession. Ally is hoping to do an IPO that will allow it to repay the TARP assistance, but those plans are on holding pending a resolution of the ResCap bankruptcy proceedings.
Ally, of course, feels that the Fed stress test does not accurately reflect their capital strength. Two points that Ally made in today’s press release were that:
- Ally believes that the Fed’s loss rate assumptions on car loans and leases were unreasonably pessimistic.
- Ally notes that the Fed has the authority to convert $5.9 billion of existing capital to Tier 1 capital, which would improve Ally’s Tier 1 ratio from 1.5% to 7.6%
On Ally’s first point, while Ally may be correct given its extensive experience in auto loans (including during the last recession), Ally’s peer banks had the same rules in place during the stress tests, and passed.
On Ally’s second point, while the Federal Reserve does indeed have the authority to convert existing capital to Tier 1, our understanding is that doing so would mean a redemption of warrants that the U.S. Treasury holds for additional shares of common stock. That would mean an increased ownership stake by the U.S. government, if we’re correct on that matter. If true, it rings of “too big to fail.”
It’s also worth noting that this is not the first time that Ally has not passed its annual stress test. Turn your calendar back to March 13, 2012, one year ago, and Ally was forced to issue a press release decrying a flawed methodology. They’re getting good at this! Last time, when Ally’s mortgage exposure was greater, it pointed out that the analysis overstated mortgage risk. With ResCap now in bankruptcy proceedings (Ally put it in there on May 15, 2012, just two months after the previously-mentioned press release), Ally is likely not going to be on the hook for those losses going forward.
This news won’t really mean much for the financial-services industry, since Ally is not a public company (no IPO yet, remember) and as long as depositors keep their accounts below the $250,000 FDIC insurance limit, should Ally ever fail, their deposits would be covered by the FDIC. But forcing Ally to retain more capital could make it more difficult for the bank to be as lenient as automaker partners may want it to be when it comes to approving auto loans. Much of the renaissance of the U.S. auto industry since 2009’s low point can be attributed to easier borrowing terms and more free-flowing credit, so it’s important for the auto industry that Ally keep writing loans. If not Ally, then other banks.