Video Update: Mapping Out the Future for Our Fortress Banking Plays

The good thing about a simulated disaster is it helps us see where banks stand today… and what will really happen if catastrophe strikes.

In today’s video update, Chief Analyst Adam Galas goes over the results of the recent Fed bank stress test – specifically, how our Fortress banking picks performed.

Even in the worst-case scenario, he’ll detail how we not only won’t lose money… But we’ll also secure a safe, high-yield income stream.

Click the image below to watch the video or scroll down to read the transcript.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome, Fortress Portfolio members to part two of our special video report on the Fed's bank stress test.

Now, as I said last week, I know this is a topic that is about as exciting as watching paint dry and grass grow, but I promise to try to turn it into a Michael Bay style blockbuster.

We're taking the Fed's spreadsheet drab and turning into red hot fire fab, bringing the sexy back to bank safety.

Because at the end of the day, there's nothing cooler than NOT losing money and safe ultra-high yield dividends that grow every year no matter what the economy or stock market does.

Safe high yield – that's the new hotness.

So last week we talked about what the Fed's stress test was designed to do… specifically simulate a nuking of the U.S. and global economy and what that would mean for our largest and most important banks.

Now, as you can see, it was a simulated disaster that combines the worst parts of the Great Recession with the pandemic for a truly hellish scenario.

(Source: Bloomberg)

The perfect thing to help you sleep well at night if all the banks passed – which they did.

Now we're going to take a closer look at what the Fed found, and what it specifically means for the three banks in our Fortress Portfolio: U.S. Bancorp (USB), Truist Financial (TFC), and Toronto-dominion (TD).

Now, as you can see, the Common Equity Tier 1 (CET1) ratio, which is a leverage ratio of a bank that measures banks assets against risk free assets, changes for each individual bank based on its business model.

(Source: Federal Reserve)

A negative number in this case means that the leverage ratio actually went down because money went into the bank.

This is because, according to the Fed, there are certain banks that are a “flight to safety bank.” These are mostly the custodial banks, such as Northern Trust Corp (NTRS), Bank of New York Mellon Corp (BK), and State Street Corp (STT).

What are these banks? Well, if you have money in Vanguard, BlackRock Inc (BLK), Fidelity National Financial, Inc (FNF), or pretty much any broker, your actual stocks are held at custodial banks.

They are the banks that other banks use to keep our money safe.

And for some reason, Charles Schwab (SCHW) also would be expected to see flight to safety money inflows.

Now, as for our Fortress Portfolio banks, USB’s CET1 ratio declined by 1.8%, which is compared to 3.3% for the median large U.S. Banks.

JPMorgan, the gold standard of U.S. mega banks run by Jamie Dimon (who is considered the modern day John Pierpont Morgan), suffered a 2.2% decline. Same as Truist Financial.

And Toronto-dominion – not surprisingly – suffered only a 1.2% decline, which is amazing and showcases why this is an AA rated, Canadian safe, banking legend.

In fact, rating agencies consider it the 20th safest bank on earth as you can see here.

(Source: Federal Reserve)

And among non-government owned banks, it is considered the 10th safest.

So now let's take a look at the most important thing that bank investors will care about: loan losses.

Now, just a quick reminder, the Fed currently expects about $180 billion in loan losses in the coming recession, consisting of about $120 billion from commercial real estate loan losses and about $90 to $100 billion expected to be lost at the original banking level.

(Source: Federal Reserve)

Now, that's about 1.5 years of profits for the entire industry that's expected to be wiped out in about six months.

As you can see below, the major areas of loan losses are credit cards, commercial loans, and real estate.

(Source: Federal Reserve)

These are the major drivers pretty much in any recession, but especially this one.

And as you can see, the actual amount of loan losses defaulting (remember, we're talking about the doomsday scenario, worse than the Great Recession, worse than the pandemic) is about $424 billion or 6.4% of all loans.

Now, that's twice the 3.1% that we saw in the Great Recession.

But remember that banks hedge against loan losses. They do things like credit default swaps for bonds, and they buy puts for securities which go up in value as prices fall.

This is why actual expected net loan to net income declines are a fraction of the cumulative loan losses.

So in this case, the Fed is expecting our coming recession to be about 42% as bad as the doomsday scenario.

Now, it's actually expected (as far as GDP declines go) to be rather moderate and mild.

But the reason that the loan losses are expected to be so severe is because of the $120 billion in expected loan losses for the commercial real estate sector.

Now, that's because of the work from home trend that affected the entire economy, and especially cities like San Francisco, which have seen their vacancy rates soar to 30% and continue climbing.

Basically, work from home is creating an apocalypse like scenario for the office space.

Luckily, that is not going to impact the broader economy.

Now you might be wondering what about your Fortress Portfolio? What is our exposure to this office property apocalypse?

Fortunately, it is essentially nothing.

We have very modest exposure to this upcoming crisis in our Money in the Bank Portfolio through Federal Realty Investment Trust (FRT), which includes about 8% of high quality office properties.

We also recommend Realty Income (O) in this portfolio. But it spun off its office property in a more recent merger.

So Federal Realty, which is in our watchlist portfolio, is our only exposure to the office property apocalypse.

Now what about actual loan losses for the banks that we do own and recommend?

(Source: Federal Reserve)

Well, as you can see, in terms of U.S. Bancorp, Truist Financial, and Toronto-dominion – the three banks that we own or recommend – they all did very well.

Better than even JPMorgan.

In fact, their net loan losses would have resulted in just a 5% to 15% earnings decline. And none of them have payout ratios above 50%.

Remember, that 50% is the safe level according to rating agencies. You want a safety buffer. If a bank has a payout ratio of 50%, even if earnings get cut in half, the dividend is still covered.

Now, with banks, a payout ratio alone cannot guarantee dividend safety. As we saw in the Great Recession, the Fed can force banks to cut dividends if their capital ratios come too close to regulatory minimums.

However, in the Great Recession, the Fed did necessarily force most large banks to cut… but there was a lot of political pressure.

Remember, the government was bailing out big banks using tax dollars. So naturally, if they kept paying dividends, that would look terrible.

This is why the Fed required anybody, any large bank taking a bailout, to slash its dividend.

And because banking panic was in the air and everyone was watching who would dare take a bailout, they needed a path forward to survive.

So the Fed basically said every big bank has to take a bailout so no one knows who actually needs one. That's why we saw all those banking dividend cuts.

Fortunately, banks are now so much safer with capital ratios that are two times greater than the Great Recession.

This is why during the pandemic, we saw no banks being forced to cut dividends by the Federal Reserve.

Now, the 2023 stress test (as all previous stress tests), is designed to ensure that we will never have another taxpayer bailout. And thus the Fed will never have to force banks to cut their dividends.

So currently, the highest risk of a dividend cut from any bank we own or recommend is 3% or less.

And that is in a doomsday Great Recession level downturn.

Remember, all three of our banks passed their stress tests even under the Robert Kiyosaki doomsday, “starvation is coming!” scenario that the Fed simulated.

That is good news indeed!

So I'd like to thank you for geeking out with me and joining us for this fascinating and oh so sexy topic – the 2023 banking stress test.

I hope you now see why we're so confident in our banking recommendations for this coming, as well as all future recessions.

Because even if they're as bad as Robert Kiyosaki’s doomsday bunker might have you fear, your dividends will be safe and keep providing wonderful income. That way, you can sleep well at night and achieve your financial goals.

I want to remind you to please send us your questions and feedback so I can respond to them in these videos and our monthly issues.

Just remember, I cannot provide personalized investment advice.

So thank you again for joining us this week and I hope you join us next week when we take a closer look at some hidden parts of the economy… that could cause other investors to freak out and suffer painful losses.

But you as a Fortress Portfolio member, will be able to sleep well at night because your dividend sensei has your back.

Remember, I watch Bloomberg and C-SPAN all day, so you don't have to. And believe me, you don't want to.

This is Adam Gauss, wishing you and your family safe investing and a healthy, happy, and relaxing week.