The Next Stage of the Banking Crisis and How it Will Impact Your Portfolio

Last week, we talked about the two scenarios that could possibly turn the upcoming “mildest recession in history” into a severe recession…

This week, we’re talking about the next phase of the banking crisis that’s likely on its way after the failure of First Republic Bank (FRC).

Chief Analyst Adam Galas discusses the cascading events that led to the current banking crisis, where we’re headed next, and shares the details behind the downgrading of one of the banks in the Fortress Portfolio.

Your Fortress Portfolio is built to withstand market volatility, recessions, record-high inflation, interest rate hikes, and any other economic or personal setback.

As Adam shows, with the power of this portfolio, you can make money while you sleep, reset your financial situation, and protect your savings from even the most severe banking crisis.

Click the image below to watch the video.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome Fortress Portfolio members to another weekly video update.

Today, we’re talking about the next phase of the banking crisis that’s likely coming now.

Last week, we talked about the two scenarios that could possibly turn this “mildest recession in history” into a severe recession… With the debt default being the biggest risk of another financial crisis.

Now, we got some new information on that from the Treasury Secretary Yellen saying that she estimates that we have at least until June 1st before a potential default.

And the Goldman Sachs (GS) model says we have till July 25th.

So I’ll be doing a two part series on the debt ceiling in the coming weeks.

But today, I wanted to highlight the important information we have about the current banking crisis, where it’s likely headed, as well as give you an update on U.S. Bancorp (USB), which was downgraded on April 21st by Moody’s.

So the good news is that according to Jamie Dimon, CEO of JPMorgan (JPM), which just bought out First Republic Bank (FRC) for $10.6 billion… The first stage of the banking crisis is likely over.

So what does he mean by this?

Well, first, let’s actually back that up with data from the last few weeks.

We have seen a slight increase in the amount of emergency bank lending from the Federal Reserve.

However, it’s still basically relatively stable at about $160 billion.

In other words, even as First Republic slid into oblivion, other regional banks were not sucked into the turmoil along with it. We also have confirmation that financial strain overall remains below average. In other words, we’re not headed for another Great Recession.

For example, the St. Louis Financial Stress Index spiked to about 1.5.

Average recessionary financial levels of stress are now back to -0.7.

Zero is the average since 1993.

So based on St Louis Fed, we’re below average levels of financial stress.

And an even more important financial stress indicator is the Chicago Fed’s National Financial Conditions Index, which since 1971, has been measuring average recession or financial stress across six different sub-indexes.

Combined, the St. Louis Fed and Chicago Fed are tracking 123 weekly indexes, including everything from loan losses to overall loan lending, credit spreads, and yield curves… Basically everything you need to know to track the state of the banking system.

In fact, the Chicago Fed’s National Financial Conditions Leverage Subindex even tracks the shadow lending schedule. Shadow banking parts of the economy. These are things like private credit.

So basically, this shows below average financial stress with the only thing showing above average and rising is the Chicago Fed’s National Financial Conditions Leverage Subindex.

In other words, the money market, banking, and shadow banking systems are experiencing some modestly increased stress, but still simply at average recessionary levels.

So what’s going to be the next shoe to drop in this banking crisis?

Well, what’s unique about this banking crisis is that normally what happens with banks and the economy in general is that as the economy grows, businesses take on loans and make various investments.

You know, the usual thing… Well after several years without a recession and without a major crisis, companies become more risk tolerant.

So they started to make more speculative investments.

Well, banks did the same things, not most of them, but some of them, such as the shadow banking sector and more speculative, less conservatively run banks.

They made bigger loans at lower interest rates and with less protective covenants because they were simply trying to grow their revenue and their earnings.

Remember what Warren Buffett said, “only when the tide goes out do you see who has been swimming naked.” Well, the longer the tide is in, the more likely people are to swim naked.

And when the economy inevitably hits a downturn, then you get loan losses. Suddenly the banks that were reckless are starting to lose money on their loans.

They’re being forced to sell other assets also at a loss, resulting in basically a mini cascade… Where the most risky loans caused asset prices to decline, forcing some other riskier banks to also realize their losses.

And then overall, banks start lending less and we get a credit crunch. With credit being the lifeblood of the economy, this is tipping point that causes a recession.

Businesses start to lose money and can’t take out loans to recover. They lay off workers and we get a downward spiral.

One thing to remember is that the average recession since World War II has been seen a 1.4% contraction, that’s half the percentage of the pandemic, and one third as bad as the Great Recession.

And there’s a reason we call the 2008 recession the Great Recession and not the “average recession.”

What’s interesting about this regional banking crisis today is that so far it wasn’t caused by loan losses.

Fascinatingly, the biggest part of First Republic’s business was making jumbo loans to the likes of Mark Zuckerberg.

In 2012, they refinanced his $6 million home at just 1%. Basically, what first Republic did is they got rich people in Silicon Valley and in New York to park all their money in their vaults, averaging about $2 million per checking account.

And they got them in the door by offering them very cheap mortgages, including interest only mortgages where you don’t actually pay off any of their principal for 5 to 10 years… And adjustable rate when rates were zero.

That allows you to borrow up to $6 million at 1%. Well, the problem, of course, is when interest rates go higher, suddenly you’re sitting on a whole lot of mortgages that are underwater.

And in fact, First Republic had $27 billion in unrealized losses.

Now the mortgages themselves were very good. As you might imagine.

Mark Zuckerberg is not defaulting on his mortgage, but if they had a bank run, then they’d have to sell these assets at a loss. Now, $27 billion is basically twice as much as all the profits First Republic has ever generated in its history.

So if they had to sell… They would be basically bankrupt, which is why the government worked with JPMorgan… To have JPMorgan basically buy them out and absorb their entire business.

The only people hurt are bond investors who will lose some money as well as the shareholders.

First Republic is completely wiped out.

So now what Jamie Dimon is saying, is that now that this stage of the crisis is over, meaning the next stage is about to begin… Regular loan losses from a slowing economy will be the next shoe to drop.

For example, if we look at the consumer default rates on things like credit cards, homes and first mortgages and second mortgages, we can see that they range from 0.27% to 3.37%.

Now, these are up, but they’re up from record low levels… Because remember, in the pandemic, we had $10 trillion in stimulus and $3 trillion in excess consumer savings.

In fact, Goldman Sachs estimates that those excess savings will take until the end of 2026 to get spent down. Basically, these default rates are simply rising to average pre-pandemic levels.

Now, of course, the nature of recessions is that we don’t return to average. We tend to overshoot it. And so loan default rates and loan losses will rise. But that’s not likely to actually cause a banking crisis.

What is likely to cause a crisis, according to Jamie Dimon of JPMorgan and Charlie Munger, Buffett’s right-hand at Berkshire since 1978, is commercial real estate.

You may have seen some headlines about this, so let me put your mind at ease and give you the facts. Currently, there’s $4 trillion in commercial real estate loans. In the next five years, $2.5 trillion is coming due, including $1.5 trillion in the next two years and about $500 billion by the end of this year.

Now, most of these loans, about two thirds, are owned by regional and community banks.

But let me give you an important concept of how these loans work. Basically, real estate is naturally a very leveraged sector.

The way it works is you buy a property with, say, 50% money down and then you use the rent to service the actual loan.

It’s called non-recourse self-amortizing debt, and such hedge fund giants as Blackstone (BX) and Brookfield Asset Management (BAM) have made investors fortunes using this method in a safe and prudent way.

So what happens when interest rates soar and parts of the economy, such as office properties crash? Well, then basically refinancing this debt and mortgages becomes a lot more challenging.

And remember, the way this industry is built. For real estate, you don’t actually pay off the debt. You simply refinance, you roll it over.

And as long as you keep servicing the interest with just a fraction of your rent, it’s a sustainable and safe business practice.

But the problem is, if interest rates soar too quickly, as they have now (5% in a year – the fastest rate in 42 years) this can cause property values to crash… As you can see in offices, of course, hurt by work from home.

Prices have fallen 25% in a year. Apartments are down 22% in a year.

Now, apartments have actually been thriving since the pandemic, but the issue is they were so overvalued that when interest rates went up, they still fell significantly in value… And malls fell 18%.

Overall, real estate is being hit hard, but still nowhere near Great Recession levels.

Now, the problem is that when these loans come due and you have a general sized banking crisis at the regional level… Banks start basically pulling back on lending, and it can be much more challenging to refinance this debt.

As Howard Marks recently mentioned in his wonderful podcast, banks were previously willing to lend $800 million at 5% and now are willing to lend $500 million at 8%.

Well, God help you if you can’t find that other 300 million, then basically you have to default.

So you might have seen some headlines about Blackstone, Brookfield and even PGIM: Global Asset Management, which is the asset management arm of Prudential Financial (PRU). They’ve defaulted on some of their office properties in cities like L.A.

Now the reason for this is that they basically look at what the cost is of refinancing at current interest rates and what does that mean for the interest costs versus the rent?

Now remember, rents are falling for these properties because vacancy rates at the national level are approaching 20%, roughly double that of the Great Recession.

That’s from remote work. And in some cities such as San Francisco, it’s actually 30%, 7.5 times pre-pandemic levels.

So for an asset manager like Brookfield, they’ll simply ask, what is that new interest cost versus the rent we will be collecting?

Does it make sense if the interest costs are higher now than rent? If too much of the rent is eaten up by interest, is it still profitable?

If not, they hand over the keys as the saying goes. They default by simply basically handing over the property to the creditor who then can’t come after them for the remainder of the debt. And then they can’t touch anything else that they own.

Basically, think of it like a mortgage. If you can’t afford to pay your mortgage, the bank takes the house, but you’re not on the hook for the rest of the loan.

Well, the problem with this is… What’s the creditor going to do with this office building that Brookfield doesn’t want?

The creditor doesn’t want it either. They want to get their money back as much as possible.

So they’re going to try to sell it. But remember, office properties are prices are down 25%. So they’re going to sell it at a loss. And by actually selling it, they’re increasing the supply while demand’s not very high.

That’s why the prices are low and that drives prices down even lower. Well, that essentially means that anyone else with similar types of properties, such as commercial mortgages, are now underwater and they’re more likely to have to also default on their debt.

So this is essentially what can cause a bit of a domino chain to fall. But it’s important to point out that while this isn’t the most likely other shoe to drop in the regional banking crisis, it’s also not likely to cause another financial crisis.

And here, let me show you why. Right now, there’s $4 trillion in commercial real estate loans.

Now, that’s one third the size of the subprime mortgage market in 2008 at $12 trillion.

And, the subprime wasn’t actually what caused that major housing downturn to turn into a financial crisis that was $683 trillion in derivatives, things like credit default swaps.

For context, that was about seven times the size of the global economy at the time.

So let me give you a specific example, Citigroup(C). Not only in 2008 did they own lots of subprime and real estate loans, they were also 40 times leveraged with derivatives. In 2008, subprime bonds were owned by the likes of Bank of America (BAC) and insurance companies like Prudential Financial Inc (PRU) and Manulife Financial (MFC).

And remember, these were toxic loans that in a downturn would lose much of their value.

Today, none of the banks we own utilize these kind of toxic loans. And none of the big insurance companies we recommend do either.

But today, there are some low quality trash loans in that sea of $4 trillion commercial real estate loans. These are, of course, the kind of speculative properties in cities that no one wants to live in, and properties that no one wants to rent.

Now, the bad news is, yes, there are banks that do own these commercial real estate loans on their books.

But here’s why, and it’s not a reason to lose sleep over today. The credit reserves of the banks are twice that of the Great Recession.

The Fed also does annual stress tests, but ironically it has not tested for rising interest rates since 2015.

And even when they did, they never thought interest rates would go above 2.5%. Very ironic.

But what the stress tests do, is stress test for is another great recession. After all, generals are always fighting the last war.

Well, the last stress test, which all of the banks passed with flying colors, (including U.S. Bancorp., which we’ll talk about in a minute), simulated a 38% crash in home prices, and a 40% crash in commercial real estate prices, with unemployment soaring to 10%. In other words, they simulated a scenario slightly worse than the Great Recession.

And all the banks passed, including U.S. Bancorp.

And here’s the key takeaway. The Fed always hikes until something breaks, in other words, some manner of financial crisis occurs.

But when you hear financial crises, don’t think the Great Financial Crises, just think of something going wrong. For example, the Fed hiking to 20% in 1980 caused the Latin American debt crisis of 1982.

It also caused the savings and loan crisis that wiped out 30% of essentials in the 1980s.

Well, how many recessions did that cause? None.

How did the stock market do? It was going like gangbusters in 1994.

The Fed was raising rates and orange County went bankrupt in 1994. Mexico also defaulted on its debt.

In 1997, we had the Asian currency crisis. In 1998, the Russian default crisis, which then triggered the long term capital management crisis.

All of these were financial crises, but none of them caused recessions.

At worst, they caused historically average and healthy corrections.

So let me show you why you shouldn’t be worried about banks in general for your Fortress Portfolio, specifically using U.S. Bancorp as an example.

Now remember, this is our newest recommendation and one of my strongest conviction opportunities for Buffett-like returns from a blue chip bargain hiding in plain sight.

Moody’s downgraded them on April 21, as well as ten other regional banks in addition to the overall U.S. banking sector as a whole.

Now, that might sound terrifying, but I’ve carefully read through that downgrade. And what Moody’s is basically saying is that the overall banking sector is being stressed by higher funding costs, i.e., interest rates that are at 5%, which is a lot higher than a year ago when they were zero.

Well naturally, that is a stressor. But here’s the important takeaway. Moody’s previously had rated the entire U.S. banking system as very strong. It’s now rated strong plus.

Well, what exactly does that mean? Let’s take a look at the U.S. Bancorp ratings to give you an idea of how a downgrade doesn’t necessarily mean you should be worried.

Before this downgrade, U.S. Bancorp was rated A3, basically equivalent to A+. It’s now rated A2 stable. So what does that actually mean?

Well, an A+ rated bank has a 0.6% chance of failing in the next 30 years. And an A rated bank has a 0.66% chance, almost 10% worse. And for context, the probability of debt default, according to the bond market, is currently 1.76%, three times higher than USB’s chances of failing.

And according to Goldman Sachs, the risk of nuclear war with Russia is 2.5%, four times greater than USB failing.

In other words, even a downgrade of a safe bank can mean it’s still a safe bank. That’s why we focus on the world’s best companies. Because, of course, something can and will go wrong. That’s inevitable. But when you have a safety and quality buffer like we do, then even if something goes wrong, you can still sleep well at night.

And how can we tell? Well, not only do we have a 3000-point safety and quality model that factors in all the data from every analyst, we also have real time fundamental risk alerts set up for every rating agency and the bond market we follow.

I’ve since improved that model to make it 2% more accurate and faster to update in a recessionary crises. For example, when earnings break and we get notifications from rating agencies of, say, 12 different companies with falling fundamentals.

We can update that in a matter of minutes so that we can always know the safety and quality of the companies that we recommend that you own in your Fortress Portfolio.

That is our promise to you. We never panic. We always follow the facts and reasoning to their logical conclusions. And that’s how we do all the hard work.

So you can relax, sleep well at night, and enjoy your safe, generous and steadily growing income, not just in good times, but especially in the bad times.

That’s how we can help you achieve your financial dreams, including retiring in safety and splendor. Thank you for joining us this week.

And a reminder, please send us your questions and comments so I can respond to them in these videos as well as our monthly issues.

Just remember, legally, I can’t provide individualized investment advice. Thank you for joining us for this week’s video and I hope you join us for next week’s part one of a two-part mini-series on the debt ceiling crisis.

The most important thing you’re probably not paying attention to, and neither is the media.

Until then, this is Adam Galas, wishing you safe investing and a healthy and relaxing week.