Stress Tests & Share Buybacks

Brian Hicks

Updated March 31, 2015

Strength Through Ambiguity

In the latest round of stress tests, the Federal Reserve gave the green light to the capital plans of 29 out of 31 banks. The American divisions of Deutsche Bank AG (NYSE: DB) and Banco Santander, S.A. (NYSE: SA) were the exceptions, and Bank of America Corporation (NYSE: BAC) was granted a conditional pass.

In what is likely a political move, the Fed cited “deficiencies” in predicting how well Bank of America would perform during an economic downturn and “weaknesses” in its internal controls.

The Fed declined to clarify what either those “deficiencies” or “weaknesses” were, instead choosing to remain unapologetically unclear.

Despite its ambiguous criticism, the Fed opted to chew Bank of America out instead of rejecting its capital plan altogether, giving it a September deadline to resolve its nonspecific issues and resubmit its plan.

I’m all for government organizations overseeing big businesses, particularly when it comes to big banks, but the latest barrage of veiled critiques seems to be intentionally missing the point.

Juking The Stats

I don’t mean to portray Bank of America as an entirely blameless victim. BAC recently bought back $4 billion worth of its own shares. This is part of an emerging trend of several other big companies doing the same in various amounts that total in the billions.

While this can be interpreted as companies seeking new ways to invest in themselves due to expected growth and proof that others should follow suit, there’s also a lesser-known, artificial benefit to share buybacks.

When a company purchases its own shares, the amount of volume or available shares on the market is reduced. A company’s earnings are calculated by dividing total income over the amount of shares.

If there are fewer shares on the market, anyone who calculates a given company’s earnings will come up with a bigger, manufactured number.

Bad Business

So not only did Bank of America spend $4 billion to attract new investors under false pretenses, but it passed on an opportunity to raise its dividends, which would not only attract new investors as well, but would also be good business for everyone.

Any company that beats average projected earnings is a big deal, and a company that misrepresents itself in order to do so isn’t a company that I would recommend to anyone.

If share buybacks are to become the new trend for companies with big coffers, what’s to stop them from buying back shares a couple days before the deadlines for announcing quarterly results in order to beat earnings?

Share buybacks do not constitute a positive market change. They simply remove shares from the market, lowering the divisor for earnings-per-share (EPS) calculations, which benefits the higher-ups at the companies in question and no one else.

In the interest of seeing a healthy, expanding market, companies must represent themselves accurately, not reduce the amount of shares at the first sign of trouble.

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