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Ahead of New Stress Tests, 3 Banks May be Vulnerable

Investors drove the Dow and S&P lower Wednesday, with Wall Street again in the 'sell first and ask questions later' mode.

Largely pros were wondering if the stock market can rally at all, in the wake of the Fed’s decision to require banks to undergo another round of stress tests.

On Tuesday, the Fed told the market it intends to require another round of bank stress tests for as many as 31 US financial institutions. Last time around only 19 firms were stress tested.

And that’s triggering an obvious question – which banks are most likely to have trouble?

Exile on Wall Street author Mike Mayo of CLSA has been parsing through bank data, statistics and metrics for quite some time. And his proprietary research has flagged 3 banks - Bank of America, Citigroup and Morgan Stanley as most vulnerable.

Although his complete analysis is very complex, we've attempted to pare it down for you. And in a nutshell Mayo believes all 3 banks mentioned above employ “inconsistent strategies, unstable management and bad risk management.”

But those aren't Mayo's only concerns, he has another worry and this one impacts the entire sector.

Mayo thinks the stress tests may drive the financial sector higher under false pretenses. "After the stress tests are over, investors may have a false sense of confidence," he says.

In other words, once banks pass the new stress tests, the results could generate confidence that US banks have enough capital to weather even the worst crisis. In turn that would make a stock like Bank of America, which is trading at a huge discount to book, suddenly seem like an attractive value.

”But, In 2006 who would have factored in AIG failing,” Mayo says. "The stress tests won't show the ripple if another big insurance firm fails. They won't show the exposure banks have to hedge funds that are in turned exposed to problem European nations."

We take that to mean although it took a black swan event to take down the banks in 2008 – the market did, in fact, experience a black swan event.

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Trader disclosure: On Nov. 23, 2011, the following stocks and commodities mentioned or intended to be mentioned on CNBC’s "Fast Money" were owned by the "Fast Money" traders: Karabell is long APL; Karabell is long MS; Karabell is long IBM; Karabell is long GOOG; Karabell is long ORCL; Karabell is long CAT; Karabell is long JOYG

For Zach Karabell
Rivertwice is short XLF
Rivertwice is short SMH
Rivertwice is long IBM
Rivertwice has long calls HPQ
Rivertwice is long QCOM
Rivertwice is long ORCL
Rivertwice is long DE

For Josh Brown
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For James Lebenthal
Lebenthal is long C
Lebenthal is long XLF
Lebenthal is long MPC
Lebenthal is long CAT

For Irwin Simon
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For Colin Gillis
BGC Financial LP and/or its affiliates, expect to receive, or intend to seek, compensation for investment banking services within the next three months from all of the companies referenced within this report (AMZN).

BGC Financial LP and/or its affiliates, expect to receive, or intend to seek, compensation for investment banking services within the next three months from all of the companies referenced within this report (AAPL).

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