Video Update: The Next Shoe to Drop in the 2023 Banking Crisis

There’s a ticking time bomb in the financial sector.

Today, Chief Analyst Adam Galas is going to break down all the details on:

There are many participants and factors at play. But here’s what you need to know…

Our Fortress Portfolio is full of companies focused on safety and dividend growth. And Adam will share how they have what it takes to survive a crisis like this.

Plus, in our next monthly issue coming out this week, we’ll highlight one play that’s trading at a discount and will give an opportunity to boost our returns.

Welcome Fortress Portfolio members to another weekly video update.

Today, we're talking about the next shoe to drop in the banking crisis of 2023. Last week we talked about the introduction of what's going on with Silicon Valley Bank.

And this week, of course, we have a slightly larger and more important bank, First Republic of California, slightly bigger as the 15th largest bank in the country.

So you might have noticed that First Republic Bank (FRC) has fallen off a cliff.

Monday, it fell another 50% down to $12, compared to 130 before this crisis about ten days ago. So what's going on? Well, S&P downgraded them on Sunday, a second time in a single week to B+, indicating a 25% chance that they're going to go bankrupt just ten days before that.

It was an A-minus rated bank with a 2.5% chance of bankruptcy. So what happened?

Well, on Friday, March 15th, First Republic issued an 8-K filing that had some very troubling information. To be specific, in the previous week FRC had borrowed $100 billion from the federal government at rates of between 4.7% and 5.5%.

More troubling is that they have 60 days to repay it.

The full amount is due on May 15th plus interest or five days after that, on May 20th, the government starts liquidation proceedings, in which case they start to sell all the assets, including those bonds that are $5 billion underwater. Well, the problem of course, is that for a $2 billion market cap bank, if you have a $5 billion loss, effectively, you wipe out the shareholders.

So what about that $30 billion rescue deposit loan from 11 banks?

Well, S&P says that's not going to be a long-term solution.

And the reason for that is, FRC borrowed $100 billion from the government to cash out depositors fleeing the bank, 67% of which were uninsured deposits.

The average account at First Republic is $1,000,000. This means that most of the wealthy clients are trying to escape with their money because they're not sure if they'll be made whole if the bank fails.

Half the depositors left have left so far, including $90 billion in the last week. Now, the reason this matters is that analysts estimate that First Republic, in order to remain in business and keep the lights on, needs $100 billion in deposits. Well, they have about $120 billion right now. If you include those $30 billion that the banks put in.

But they only agreed to put that in for 120 days. Now, JPMorgan (JPM) has been negotiating with the banks to try to make that potentially permanent, essentially turn it into stock or just acquire the company outright.

Well, that news sparked a share price drop of over 50% on Monday for FRC because a $30 billion bailout on a $2 billion market cap, could mean a 93% share dilution.

And that's why I recommend nobody buy this bank. It is pure speculation.

And remember, right now their depositors are fleeing.

In fact, even if depositor flight were to drop to by 10% like we saw last week and that management confirmed—in the next two months, if it drops by even $11 billion or more, they simply don't have enough deposits to stay profitable as a bank and they will fail anyway.

Basically, there are only three ways this can end.

One, depositors come back, as they ironically have at Silicon Valley Bank (SVB). Crazily enough, about 650 companies returned, but only because FDIC is now insuring all deposits—which is not the case with FRC as of now.

Second (and most likely), someone could buy them for pennies on the dollar in a government backed deal as happened with Credit Suisse when UBS bought them for $0.04 on the dollar. And this essentially wiped out shareholders as well as bondholders who lost $17 billion.

Or they could simply fail outright. And the FDIC takes them over and sells them off for parts, which is currently what it looks like is going to happen with Silicon Valley Bank regardless of the fact that depositors started returning.

So what does this mean for the economy? Well, regional banks are facing some stress in terms of outflows although not nearly as much as First Republic or Silicon Valley Bank.

That's because the average deposit size at Silicon Valley is $4.5 million, $1 million at First Republic, both uninsured. 93% of SVB was uninsured, 67% for First Republic. For the average bank, though, their deposits are usually $50 to $100,000 with a median of $6,000. So in other words, at most banks there's not necessarily a lot of fear because their accounts are insured.

However, this still could cause a problem because we are concerned about companies.

If you're a small business, you might have a $1 or $ 2 million in your account. Well, guess what? If you're worried that your bank might fail, you're going to want to move that money to someone big like JPMorgan.

Well, the problem with that is that there are a 186 regional banks, according to a study from Stanford, that are at risk of failing.

Now, that might sound terrifying, but it's only 7% of the 4,154 banks left in this country.

However, the issue, as economists such as Goldman Sachs (GS) and Apollo Management (APO) point out, is that regional banks right now are just worried about surviving.

Guess what happens if you're worried about surviving? You're not going to be lending to small businesses.

And guess who employs 50% of Americans? Small businesses.

And guess what drives 70% of the economy? Consumer spending.

And most of that money comes from income. In other words, this means a credit crunch is possibly brewing, though it hasn't shown up in the data yet, it is potentially coming.

Goldman estimates that it would be the equivalent of the Fed hiking an extra 25 or 50 basis points.

But Apollo Management thinks it could be the equivalent of a 1.5% hike from the Fed.

Well, the problem is that currently the bond market expects the Fed to hike up to 5% before stopping.

But we can't forget that reverse money printing is still going on at a furious rate of about $100 billion a month. That effectively means we're going to go from 0% rates in March of 2022 to between 6% and 8.5% rates by May of 2023.

For context, Paul Volcker, the famous chairman of the Federal Reserve from 1979 to 1980, never hiked more than 4.75% in a single year even during his 20% interest rate crusade against inflation.

We've simply never faced rates going up this high and a potential credit crunch this severe for small business.

Now, the good news is that the recession this could cause is not likely to be anything like the Great Recession, which was three times more severe and lasted twice as long as the average recession since World War II.

However, it is coming within the next four months according to the bond market and the most recent economic data. So how bad could it be?

Well, currently the economic consensus is that it'll be a 0.5% contraction basically on par with the mildest recession in history, which was 2001. That was a 0.4% contraction.

Wells Fargo (WFC) thinks it might be a bit worse, 1.2%, starting in Q4 and lasting through Q1.

Now, the good news is that's compared to the average recession of 1.4%.

So basically a mild to average recession, lasting about 6 to 9 months depending on whether or not the Fed will actually cut.

Okay. So what does this actually mean for your Fortress Portfolio companies?

Well, let's use Allianz (ALIZY), the world's largest insurance company as well as best managed and safest rating agency, as an example.

I mentioned before that Credit Suisse was bought out this weekend for $0.04 on the dollar and bond investors were wiped out to the tune of $17 billion.

Now, this being a European company, you might think Allianz might be exposed to this. So let's take a look at just how bad that could be…

Allianz has a very conservative trillion dollar investment portfolio, 83% of which is in bonds, 92% of which are investment grade bonds, most of which are A-rated or better.

So what's the exposure like for those Credit Suisse AT1 bonds that bond investors were shocked to find out are going to zero?

Well, according to Bloomberg, the largest exposure in the world is from Pacific Investment Management Co. (PIMCO), the world's largest bond manager, for $3 billion. Invesco Ltd. (IVZ), the ETF giant, has $370 million in exposure. And BlackRock, the world's biggest ETF provider, has $113 million.

Allianz is under $100 million at least and possibly $10 to $20 million more.

Assuming they have any of these bonds at all, remember, these are high risk, low quality bonds and they are very conservative. Allianz is AA rated. And they are only one of two AA rated insurance companies in the world, the other being Berkshire Hathaway. So worst case, let's say they had $100 million in exposure and all of that went to zero.

That might sound pretty scary, but remember, Allianz is the world's biggest insurance company and they have $10.2 billion dollars in net income, meaning even a $100 million loss from Credit Suisse bonds would be less than 1% of net income. In fact, management is so confident in their forecast for $25 billion in free cash flow between 2022 and 2024 that they're recommending the board hike the dividend, up to 12% for the next year (well above the 5%+ they normally target).

And they said if the board doesn't authorize that, they'll recommend 13% for the following two years.

Again, this is a very high-quality company and management is very confident in their ability to weather this crisis.

The same is true for our other insurance company, Manulife Financial (MFC). MFC is Canadian as well as Toronto-Dominion (TD), and both have basically no exposure to Credit Suisse.

But what about the regional banking crisis? Do any of them have exposure to this?

Well, remember that a bank run is something that cannot happen at an insurance company because they take in deposits and they invest them in conservative bond focused portfolios.

The only way they can have any kind of a margin call is if there's some kind of horrific crisis, such as major hurricanes striking several places, all at once.

And of course, their risk management team is absolutely exceptional at foreseeing and preparing for these potential risks.

So what about the regional banking crisis in general? Well, none of them have direct exposure, but Toronto-Dominion might actually benefit from it.

TD is trying to buy a regional bank called Horizon Bancorp, Inc. (HBNC), which would make TD the sixth largest bank in America. But of course, when TD attempted to start making that deal, Horizon was trading much, much higher.

Now TD is trying to renegotiate the deal for a better price, or might even ditch the deal entirely and just try to buy a different, better regional bank.

As an example, analysts are talking about rumors that Toronto-Dominion has a key rival. Royal Bank of Canada is interested in potentially buying First Republic again for pennies on the dollar with lots of government guarantees to minimize any potential losses.

The point is—when you buy world class blue chips and A-rated titans like these, they don't just survive a crisis like this, they get stronger and bigger. They end up buying those lower quality companies that fail.

And this is why safety and quality are so important. We have a 3000-point safety and quality model that runs everything we do here at Wide Moat Research and Fortress Portfolio.

And we have $40,000 worth of advanced data feeds from the likes of Bloomberg and FactSet that show us all the news about hundreds of companies in our investing universe.

I also have Google sending me analyst and credit rating reports specifically related to what is going on with companies that might cause a downgrade. And finally, we have something called credit default swaps, real time insurance policies from bond investors, showing us in real time what bond investors are pricing as the fundamental bankruptcy risk for any given company.

And those are changing every day right now as news breaks.

For example, with Allianz, when the Credit Suisse news broke and all this financial chaos started last week, it's fundamental risk of bankruptcy for the next year went up 70%, which sounds terrifying… But it's actually just 0.26% for the next year for Allianz because that part of the portfolio is miniscule compared to the rest. And according to S&P, just 0.55% for the next 30 years.

In other words, while there are no guarantees on Wall Street, buying and holding Allianz during this incredible chaotic time in financial markets is about as close to a guaranteed win as you'll ever find in the real world.

So I want to thank you for joining us for this weekly video update.

And I'm excited to announce that next week we’ll be talking about a very hot topic—how the banking crisis could actually make inflation even worse.

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

But remember, I cannot provide personal investment advice.

I hope you join us for next week's very exciting video update.

And until then, this is Adam Galas, wishing you safe investing and a happy and relaxing week.