Video Update: How 1,000 More U.S. Banks Could Disappear in the Coming Years

The banking crisis continues.

By the time all is said and done, we could have 1,000 fewer banks in the U.S.

With the debt ceiling deadline fast approaching, it’s important to be prepared for even the worst-case possibilities.

Chief Analyst Adam Galas will lay out everything you need to know that could lead up to this scenario… why this may sound scary – but you shouldn’t be worried… and how our Fortress Portfolio is designed to protect you through it all.

Click below to watch the video.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome, Fortress Portfolio members, to another weekly update.

Today we're talking about why America will likely soon have 1,000 fewer banks.

Now, last week we talked about the banking crisis and specifically why the JPMorgan (JPM) acquisition of First Republic Bank (FRC) likely means the end of phase one of the three phase regional banking crisis.

Now, I promised part two of the four-part series on the debt ceiling crisis in the final three weeks of May. Next week, I will deliver on that.

I will also share everything you need to know about what S&P, Fitch, and Moody's call a potential cataclysmic financial catastrophe that could be worse than the Great Recession (of 2007-2009).

But right now, we still have several weeks to go before the U.S. Treasury Department potentially defaults on our debt.

Treasury Secretary Yellen thinks June 1st at the earliest. Moody's thinks June 8th, JPMorgan assumes June 9th, at the earliest.

And Goldman Sachs thinks we until sometime in July.

So now let's talk about what's going on with the U.S. regional banking crisis and why we're likely to have a thousand fewer banks within a few years.

And why that's perfectly okay as well as what it means for the Fortress Portfolio.

So last Wednesday, the Federal Reserve raised interest rates for the 10th consecutive time to 5%.

And during the press conference when asked about the state of the banking system, Jerome Powell said it was sound and that they are on top of it.

Well, 30 minutes later, PacWest Bancorp (PACW) was down 55% after hours.

The next day, high risk regional banks were down 22%. Regional banks overall were down 6%, U.S. banks in general were down 5%, and Western Alliance Bancorporation (WAL) fell as much as 62%.

Rather hilariously poor timing on Mr. Powell’s part. But here's what actually happened.

PACW plunged as much as 60% after hours because it reported that it was looking to sell itself.

Remember, First Republic Bank had spent over a month trying to do the same thing, and we know how that turned out.

Well, the reason PACW is currently trying to sell itself isn't because it's worried about a bank run like Silvergate (SI), Signature (SBNY), Silicon Valley (SVB) or First Republic.

It has cash and liquidity enough to cover 188% of its deposits and 75% of its deposits are insured. You heard that right, 188%. This means that they have $1.88 in cash plus borrowing power for every $1 in deposits.

In other words, if every customer wanted their money back right now, they would be able to give it to them.

And a bank run literally cannot kill PACW. But what might hurt the bank is the higher funding costs. Remember, the Fed just raised interest rates from 0% to 5% in just over a year.

And as you can see, that is the fastest rate in 42 years by far.

Remember how banks work. Your deposits are low-cost source of funding, which they then use for higher interest long term loans such as mortgages, car loans, credit cards and commercial loans. After accounting for loan losses, the average bank generally makes between 2% and 3% profit on this interest rate differential called a net interest margin.

And by using 6 to 12 times leverage, depending on the bank in question, that's how they earn their millions or billions.

PACW was founded in 1999 in Beverly Hills, California, and is the 53rd largest bank in the country with $42 billion in assets. Since 1999, it’s earned a cumulative $3 billion.

The problem is in Q1, it lost $1.2 billion, an annualized rate of -$5 billion per year.

That's because its funding costs have soared so high that it's now losing money as an overall banking business.

And if it keeps losing money at this rate, it'll be dead within six months.

That's why it's trying to sell itself, and it will likely succeed… But only after the Federal Deposit Insurance Corporation (FDIC) puts it into receivership and then cuts a deal with a large regional bank like PNC Financial Services (PNC), who was the runner-up to buy First Republic.

So what about Western Alliance? Well, this is an Arizona-based bank, and it's the 40th largest bank in the country. It fell as much as 62% in a single day when the Financial Times reported it was looking to sell itself.

Well, management came out right away and said that is a complete lie. We are not trying to sell, and we are just fine.

And for now, that is actually true. Western Alliance has 77% of its deposits insured through something called insured sweeps. This is where a big company might have, say, $2 million in deposits. But that gets broken up among eight banks in a network of banks they work so each keeps about $250,000 and is insured.

Like PACW, it cannot be killed in a bank run because it has more liquidity than deposits.

But unlike PACW, it's reporting a modest profit of $139 million in Q1. And analysts expect that to nearly double to $219 million in Q2.

In other words, even with 5% interest rates, Western Alliance is still a profitable bank. And a bank run can't kill it. So why did Moody's just downgrade them from BBB to BB+? Basically, equivalent to a junk bond status with 14% risk of failing.

That's because of their high exposure to commercial real estate, which you remember is the next shoe to drop in the regional banking crisis.

Regional banks generate 67% of America's commercial mortgage loans.

And right now, commercial real estate is doing just fine. 2.7% loan default rates are historically very low. That's thanks to a strong economy, and record government stimulus in the pandemic.

And, of course, record low interest rates until they just increased recently.

However, The New York Times estimates that commercial real estate default rates could soar up to 10% to 20% in the coming recession, which economic data says is likely 1 to 2 months away. That's a potential $80 to $160 billion in commercial real estate loan losses for the banking system, $80 billion of which would be blow a hole in regional bank balance sheets.

Now, for context, in the last 12 months, the 143 largest regional banks in the country (part of the Kerry Regional Bank Index) made $62 billion in profits.

So you can see how $80 billion loss from just commercial real estate, never mind other kinds of loan losses could be a very big deal indeed.

Now, the average US Bank's exposure to commercial real estate according to Moody's is 1.25 times its equity or cumulative net profits over time.

Western Alliance, in contrast, which is focused mostly on Los Angeles and Southern California, is at high risk at 2.9 times its equity.

That's why Western Alliance is still a high-risk bank according to Moody's, even while its deposits have been growing in recent weeks and it is still generating profits overall.

But as a reminder, we are only just ending the first of the three phases of the banking crisis, and the first includes deposit flight and bank runs as we saw with Silvergate.

Silicon Valley, Signature, and First Republic also had negative profitability due to high funding costs. And that is phase two, which is currently killing PACW.

And then finally, in phase three, loan losses occur due to the recession. This will include the commercial real estate sector, which is the largest threat to the entire banking sector.

So now let's talk about why America is likely to end up with a thousand fewer banks.

And why that's okay.

A recent study from Stanford estimates that just over 50% of U.S. banks, about 2300, are technically insolvent.

Now, that sounds terrifying, but it's a lot less scary than it sounds.

It just means that due to unrealized losses on bonds, if every bank in America were forced to sell 100% of its assets today, all 2300 of them (including J.P. Morgan and Bank of America (BAC)),would have realized losses that wipe out their cumulative profits, their equity.

Now, remember the reason banks are sitting on $620 billion in bond losses is because of the government.

Government regulations forced the banks to own mostly risk-free bonds as collateral against their other loans. Then the government, via the Federal Reserve, jacked up rates at the fastest rate in 42 years. This resulted in the worst bond bear market in U.S. history, generating those unrealized losses.

And the reason the Fed had to do that was because of the worst inflation in 42 years. This is the result of that $10 trillion in stimulus spending during the pandemic. As it turns out, we needed 40% or $4 trillion to plug the hole left by the pandemic. And 60% was excessive spending. Thus, the reason for inflation, high interest rates, and the problems with the banks.

Now, according to Stanford, about 10% of banks or 413, were financially weaker than Silicon Valley before it imploded in a $40 billion single day bank run.

That next day it was scheduled to see $100 billion in deposit outflows, which is why the FDIC shut it down.

Now, Stanford estimates there are about 191 high risk banks that might actually fail, and they collectively have $300 billion in assets.

Now, First Republic for context was the 14th largest bank with $212 billion. There are a few banks larger than First Republic, but none of them are likely to actually fail.

The 13th largest is Citizens Financial (CFG), which just bought Silicon Valley's assets. Now, before it did that, the U.S. government did a deep dive on its financials… Because God help us if a bank buying a failed bank turns out to fail itself. That would cause economic chaos.

The banks, larger than Citizens Financial are custodial giants, Bank of New York Mellon Corp (BK) and State Street Corp (STT). These are the banks used by other banks.

For example, if you own index funds or mutual funds at BlackRock (BLK), Vanguard or Fidelity National Financial Inc (FNF), those are the banks that are holding those shares. Above that are the super regionals, Truist Financial (TFC), PNC and U.S. Bancorp (USB).

These are the national titans with thousands of branches in dozens of states, and business models that are so diversified that they do everything the mega-banks do other than investment banking.

That's why they're not globally systemically important banks or G-SIBs.

G-SIBs have higher capital requirements depending on what level or bucket they're in. The highest bucket, of course, would be JPMorgan Chase (JPM) (the Mack Daddy of U.S. banks). Wells Fargo (WFC), Citigroup (C), and Bank of America are one level lower now.

JPMorgan thinks First Republic is now worth about $3.5 trillion in assets with $30 billion in overnight liquidity available. This is after buying First Republic for $11 billion.

Now, all the banks have access to three lending facilities from the Federal Reserve.

After First Republic was bought, the amount of emergency lending from the Fed by the banks was cut in half.

Now, when Silicon Valley collapsed, the amount of emergency borrowing instantly jumped to $160 billion. It started trailing off in recent weeks and then started climbing back, but it's basically relatively stable now.

So there will be future banks that fail, but remember, on average, four banks fail per year.

And we've already had four this year.

Three of them were very large.

But what about PACW? Well, it has $44 billion in assets. Western Alliance has $67 billion.

Now, Comerica (CMA) and Zion Bancorporation (ZION) are the 36th and 37th largest banks in America, with $85 and $90 billion in assets, respectively.

They're on the high-risk list, according to Moody's.

Now, the FDIC has $100 billion left in its reserves after spending $34 billion to rescue these four failed banks…

It looks like the Fed is going to be charging extra fees to large banks over $50 billion in assets to replenish that fund.

Now, the reason that the First Republic sale was structured as it was to JPMorgan was to reduce the FDIC losses by 75%. This effectively gave it four times more rescue power for deposits.

In other words, that $100 billion, if future bank failures are structured like the First Republic buyout was, would allow the FDIC to insure $400 billion and even more. Because remember, it's going to refill that fund by charging large banks.

Now, JPMorgan alone with $30 billion in liquidity left, could theoretically buy three more First Republic sized acquisitions.

But it's not actually going to do that. It's probably not going to do more than one and only if asked for that by the government… Because, of course, that would reduce its own liquidity and might make its shareholders nervous as well.

But the point is, according to Stanford, JPMorgan could on its own handle two thirds of the $300 billion or less worth of future bank failures in terms of assets.

Bank of America, Citigroup and Wells Fargo also have plenty of ability to buy failed banks, though they would need waivers from the Office of the Comptroller of the Currency. This is because federal law doesn't allow banks with over 10% of deposit market share to buy other deposit-based banks.

Wells Fargo, of course, is still under an asset cap from the Fed from its 2016 accounting scandals, which Wells Fargo management says they expect to be lifted in 2024.

Now the government wants regional banks to buy failed regional banks simply because they don't want big banks to get too big.

Well, the good news is that, as you can see, U.S. Bancorp, PNC and Truist are not just the largest super regional banks.

They're also the strongest. That's why the government included them in the $30 billion rescue alliance to try to save First Republic. And those deposits have not gone back since JPMorgan bought the bank.

Now, the rescue alliance was made up of JPMorgan, Bank of America, Citigroup and Wells Fargo, the mega center banks… investment banking giants Goldman Sachs and Morgan Stanley… custodial titans State Street and Bank of New York Mellon… Plus U.S. Bank, PNC and Truist, the Super regionals.

In other words, according to the U.S. government, these 11 banks are the strongest banks in the country and who the government calls on when other banks failed to prevent a runaway banking crisis.

So why does America have so many banking issues? That's because we have too many banks.

In 1921, America had the peak number of banks, with 31,000 banks covering 108 million people. That’s one bank for every 3,500 Americans. In the Great Depression, 9,000 banks failed within three years.

The number of U.S. banks climbed slowly to about 15,000 by 1980, at which point it fell off a cliff and has been steadily declining for the last 43 years.

This industry consolidation was kicked off by the savings and loan (S&L) crisis, which began with the Fed hiking rates to 20%. Once again, that caused funding costs to soar. And it resulted in 33% of all savings and loans failing by 1995.

Now, the savings and loan crisis didn’t cause a recession. But there was a recession in 1990 when Iraq invaded Kuwait and oil prices went over $100.

Congress did have to step in and rescue the industry. That cost taxpayers $124 billion when all was said and done. But overall, it was a long, prolonged crisis for a single industry that did okay, that didn't hurt the economy too much. And the stock market, of course, did extremely well.

Now, in the Great Recession, there were 7,500 banks. And since then, the number has been almost cut in half.

Remember, we average about four bank failures per year, which means that the falling number of banks is not because of bank failures, but simply because of acquisitions. So let me explain why bigger banks generally are better.

America is the fourth most over-banked country on earth when measured by bank branches per million people. We have about 1,383 branches per million people. That’s one bank for every 80,000 Americans.

Canada, which is famous for its banking stability, has 34 banks and credit unions for the entire country. One bank for every 1.1 million and 207 branches per million. In other words, the U.S. has 14 times more banks per capita than Canada and six times more branches per capita.

Now, of course, there are good and bad things about banking concentration.

Canada's top five banks control 90% of that market, and their banking costs are relatively high. That's why they have the best banking profitability in the world. Then 30% returns on equity.

But it's also why deposit rates suck. Even by U.S. standards, where the average checking rate is 0.37% interest. In Canada, it’s 0.037%. Even with their rates at over 4% in the U.S., 67% of small business lending is from small and medium sized banks.

So generally, having more banks with more competition and lower rates does increase credit and help small businesses, and thus the economy, grow and. But there is a downside to having too many banks.

Remember back to 1921. Now imagine a town with 3,500 people. They have a single bank. How safe do you think that bank is in a severe recession? Probably not very.

Which is why 9,000 banks failed in the Great Depression.

How many Canadian banks failed? None.

In fact, since 1921, there's been only one Canadian banking failure. And that was caused by fraud, not weak balance sheets or loan losses. In fact, the last time Canada had a banking crisis was the 1840s.

Since then, regulators have ensured that bigger and stronger is the law of the land, so that in every banking crisis of the last 180 years, Canadian banks can be trusted to be the safest in the world.

That makes double A-rated Toronto-Dominion and Royal Bank of Canada stronger than even the strongest U.S. bank.

So how many banks should America have? Well, imagine a town of 80,000 people with a single bank. That’s certainly better than 3,500. But in a severe recession, you might still be worried that that bank could fail. Well, that's what America has today, 12.5 banks per million people.

Now, imagine a city of 1.1 million people with just one bank. Surely that city can sustain a bit more than one bank. And that's Canada today with its legendary banking stability. The downsides are lack of competition and high price.

But remember, stability is what the Canadians are after in the last 200 years. That’s how it’s had one banking crisis compared to America’s 10.

Now, halfway between Canada and America, it's about six and a half or seven banks per million people, or one per every 150,000 Americans. That would still be seven times more banks per capita than Canada and about 2,000 banks today. Plenty for local and community banks, but powerful and safe regionals.

But Americans do love their choice, and they're famous for their distrust of big banks.

That's why Andrew Jackson killed the Bank of the United States in 1836 and why it took until 1913 and eight bank crises along the way for us to establish the Federal Reserve.

So let's say Americans say we want 10 times more banks per capita than Canada. That still means we have 25% too many banks, and we don't need to consolidate 1,000 more.

But this, of course, is not going to happen overnight or even in the next year or two. This is over the long term. Say the next five or ten years.

And it's not because 1,000 banks are going to fail, but simply because we're proceeding on the natural and healthy 43-year consolidation phase that began in the 1980s.

Now, what does this mean for Fortress Portfolio?

Fortress has two banks, U.S. Bancorp and Toronto-Dominion. Toronto-Dominion is the largest bank in Canada, the 10th largest bank in the United States with 1.4 trillion in assets and 386 billion in U.S. assets.

Recently they called off their attempted acquisition of First Horizon, which is the 38th largest bank in the United States, with $78 billion in assets. Had they bought that, they would have become the eighth largest U.S. bank behind US Bancorp, PNC and Truist.

Now, Toronto-Dominion will likely try to buy another regional bank, possibly taking advantage of the bargain basement prices we're seeing now. By law, the FDIC must accept the best bid that minimizes its funding loss. That's why they took the JPMorgan bid.

Toronto-Dominion, of course, has deep pockets. At least 14 billion to buy First Horizon, but possibly even more.

The latest news on why that deal fell through is that apparently U.S. regulators didn't like their safeguards against money laundering. They're not accusing them of money laundering. They're simply saying that they're not doing enough to potentially prevent it in the future.

I consider that a bit ridiculous given the current banking crisis. It's like questioning the ethics of Warren Buffett when he's attempting to bail out Goldman Sachs and Bank of America in 2008, based on the fact that their safeguards are in the top 5% of their industry, according to S&P. It's like saying to LeBron James, I don't think you should be on the U.S. Olympic basketball team.

Well, the point is that Toronto-Dominion bidding on failed banks is a potentially wonderful thing that could drive further growth. And let me explain why.

Consider Zion Bank, with $90 billion in assets, and if it fails. It’s on the Moody's high-risk list. TD could probably buy it for $4 billion. That's compared to nearly $14 billion that they were using to buy First Horizon, which is smaller.

In other words, Toronto-Dominion could potentially be able to buy four times more regional banking assets in this crisis. This is why it's so wonderful to own world-beating blue chips. In a crisis, they don't just survive. They thrive and get stronger with every passing crisis.

What about US Bancorp?

Last week, we talked about the Moody's downgrade on April 21. That was along with 10 other regional banks being downgraded. Moody's said the reason for that was they're a bit concerned because in late 2022, US Bancorp bought Union Bank, so their capital reserves have decreased a bit. At potentially the worst possible time.

But they are confident in management’s plans to increase that buffer quickly in 2023 and beyond. In fact, Moody’s is so confident that they say there's just a 33% chance of a future downgrade. And remember, it's rated “A,” down from A-plus, meaning a 0.66% chance of failure. And their deposits are rated double A, meaning a 5% chance of going bankrupt.

What about commercial real estate? Remember, we're looking at a potential $120 billion hole about to be blown in America's bank balance sheets.

Well, the good news is US Bancorp has quote “insignificant exposure” to commercial real estate. Specifically, its exposure is 1.2 times its equity, which is about 5% less than the industry in general.

Remember, Western Alliance, which has high-risk exposure to commercial real estate, is three times. In other words, U.S. Bancorp has about one third the exposure the Western Alliance has.

So this basically means US Bancorp still has a fortress balance sheet with a very safe 6.5% yield and battle-tested management that’s so good that they remain profitable in every single quarter during the Great Recession.

For context. JPMorgan, led by Jamie Dimon, considered by many to be the greatest living banker, suffered one quarter of negative earnings. US Bancorp did even better.

That's what Fortress is all about: owning the world's best high-yield blue chips, so that even in another Great Recession-level crash (such as might be triggered by a U.S. default on its debt, which we'll talk about next week), our dividends are likely safe and keep growing.

That's why I spent so much time studying the economy, reading economists’ and analysts’ reports, and watching Bloomberg for 20 hours a week: So that I can tell you what's happening and what to expect in the future. So that when the market inevitably falls out of bed and the bears go rampaging down Wall Street, you can stay calm, safe, and rational with your hard-earned money.

I want to turn you into a stock market genius, which, to paraphrase Napoleon, means the investor who can do the average thing when everyone around him or her is losing their mind.

That's the secret to getting and staying rich no matter what the economy or market is doing. That's the ticket to retiring in safety and splendor and floating to retirement nirvana atop an ocean of generous, safe, and steadily rising dividends.

I hope you join us next week for part two of our four-part series on the debt ceiling. Part two will provide an update about the likely impact of a debt ceiling default on the economy, which is what part one was about and tell you how to potentially cash in on the coming market mayhem.

In part three, we'll explain what the debt ceiling is, why it exists, and how the government is working to avoid potential disaster.

And part four will explore the budget deficit, why it's so hard to fix, and the most likely way the United States can and will overcome that challenge.

A reminder, please send us your comments and questions so I can respond to them in these videos and our monthly issues. Just remember, I can't legally provide personalized investment advice.

Until next week, this is Adam Galas, wishing you and your family safe investing and a healthy, relaxing, and joyous week.