Video Update: War Games for the Financial System

The Fed just tested the strength of the banking sector.

Just like preparing for war with drills and war games, bank stress tests help the biggest players in our financial system prepare for crisis scenarios.

In today’s video, Chief Analyst Adam Galas breaks down what this test is, which banks must participate, and the results.

It’s a big-picture overlook that pieces together the buzzwords you’ve heard recently in the news – U.S. bonds, loan losses, interest risk – and gives you insight into what they are and why they matter.

This update will help you prepare for the future… regardless of what happens next for banks.

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

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome, Fortress Portfolio members to part one of a two part special video report on the Fed's banking stress test. The results just came out on June 22, 2023.

Now, I know what you might be thinking. This is a boring topic, but I promise you I will make it as sexy as possible.

Because, after all, safe banking is sexy, spreadsheets are cool… And as The Big Bang Theory teaches us, the geek shall inherit the earth.

So sit back, relax, and let this dividend sensei show you why bank stress tests are the new hotness.

So first, let's talk about what is the Fed's stress test.

After the Financial Crisis, the Fed began stress testing the 23 largest U.S. banks with simulated recessionary and crisis scenarios to minimize the risk of another Great Recession style meltdown that requires government bailouts.

To prevent a nuke to the global economy.

Now, these are far from perfect because, as you can see, the Fed has never stress tested rising interest rates.

(Source: Daily Shot)

For a decade Interest rates were pretty much at zero. And it doesn't take a mathematical genius to tell that when rates are at zero, they can only move in one direction.

So this is a pretty big oversight.

Now their rates have soared at their fastest pace in 42 years and are now at the highest rate in 20 years.

Banks are sitting on $700 billion in unrealized bond losses.

That might sound terrifying, but thankfully they're held in what's called the held-to-maturity (HTM) parts of the bank bond portfolios.

Since U.S. bonds are risk free, everything will be fine as long as the banks don't have to sell their bonds to cover other loan losses.

Now, if they do as Silicon Valley Bank (SVB) did, they're at risk of a lethal bank run.

This is what took down Silicon Valley, Signature Bank (SBNY), and First Republic Bank (FRC).

Now, remember, First Republic lost 50% of its deposits in the week after Silicon Valley failed.

That's what sealed its fate and ensured that it could not survive, as I pointed out, a week into the crisis.

And thus, JPMorgan (JPM) bought it out in a sweetheart deal that instantly netted it $2.6 billion in profit.

That's because it bought First Republic's high-quality loans for $0.05 on the dollar, while getting a $50 billion backstop guarantee from the FDIC.

Now, let's talk about who actually needs a stress test.

As you can see, banks with $100 billion in assets have to be stress tested every other year.

(Source: Bloomberg)

While, those with $250 billion in assets get tested every year.

And even banks that are foreign and thus have less than $100 billion in U.S. assets (as part of their U.S. operations) – if they are a global, systemically important banks or G6, they must be tested every year. This includes Deutsche Bank (DB) and Credit Suisse (CS), which is was bought out by UBS Group AG (UBS).

Now, here you can see how the 23 banks are classified into four categories.

(Source: Federal Reserve)

So, let's talk about what the stress test itself will simulate.

As you can see, it's a rather impressive simulated economic catastrophe with unemployment soaring to 10%, the same peak as the Great Recession, GDP falling 9% just like in the pandemic, and U.S. bond yields falling to zero because the Fed cuts to zero. The stock market falling 45%. Home prices falling almost 40% more than the Great Recession. And the VIX, the S&P Volatility Index, and the so-called fear gauge on Wall Street soaring to 75, almost four times its historical average of 19.

(Source: Federal Reserve)

The Fed stress tests the biggest and most important banks against this perfect storm of terrible things that have actually happened in the last few decades.

It uses these results to adjust its capital requirement regulations to minimize the risk of another global banking blowup in the future.

Now, obviously, this is not a perfect system, but think of it as U.S. military war games.

When the U.S. and its allies hold war games, they test our coordinated defense protocols to know whether we will likely win a war under realistic scenarios.

It's how we figure out the holes in our defenses so we can plug them when the people shooting at us are actually our allies firing simulated weapons as opposed to our actual enemies who are trying to kill us.

Now, as you can see, not all banks are stress tested.

(Source: Federal Reserve)

And those that are, are not all stress tested identically.

It's based on the actual business model and risk profile of each bank.

The Fed cares most about globally systemic important banks, or G6 banks. These are the banks that, if they were to fail, would trigger a domino of cascading failures that could doom the global economy to depression and despair.

Now, here you can see the specifics of what the Fed was stress testing under severe scenarios.

(Source: Federal Reserve)

GDP was falling as much as almost 13% in a single quarter.

Now, this is the scenario we're talking about today.

We're talking about a Robert Kiyosaki’s starvation is coming doomsday scenario and specifically focusing on U.S. Bancorp (USB), Truist Financial (TFC), and Toronto-Dominion (TD).

So now let's talk about the actual results.

(Source: Federal Reserve)

As you can see, compared to the Great Recession, U.S. Tier 1 capital (CET1), which measures the percentage of bank assets backed by risk free securities like U.S. treasuries, government backed mortgage bonds and bonds from nations that can print their own money and theoretically cannot default, such as the US, EU, UK and Japan, are all included in the common equity tier 1 capital ratio.

Now, this is a ratio that has risen from 5% in 2009 to 12% at the start of 2023.

The total capital ratio, which measures how much of a bank's assets are backed by total loans, including the non-risk free ones, was 8% at the time, meaning it represented 12 to 1 leverage for the U.S. banking system.

For context, before the Great Depression began in 1929, economists estimate that U.S. banking leverage was 10 to 1.

So you can see how absolutely reckless and irresponsible U.S. banks were being using things like derivatives and subprime mortgages.

Now, the U.S. banking leverage today is far better. On risk free assets such as CET1, it's declined by 60%.

And if you look at total capital ratios, leverage in the banking system has fallen by 50%.

Now, as you can see, based on this doomsday scenario that we just described, the 23 largest banks did very well.

(Source: Federal Reserve)

For example, their CET1 ratios only fell from 12.4% to 10.1%, and that was during the peak of the simulated economic collapse.

Now, based on Basil III international banking accords, the Fed has set the minimum regulatory requirement at 4.5% percent.

This is similar to where the banks were in 2009 before the safeguards that are now in place, were put in place, under the Dodd-Frank Act.

Now, the U.S. banking system, in this simulated 2023 stress test, did not come close to hitting regulatory minimums.

This implies that it would take a truly Great Depression style super apocalypse catastrophe, such as might occur in a doomsday plague or nuclear war, for the U.S. banking system to actually collapse.

Now, if you can see here, net income in this doomsday scenario fell by $190 billion.

(Source: Federal Reserve)

Now, for context, in 2023, the 23 largest banks together reported net income of $250 billion.

And furthermore, you can see here that Toronto-Dominion and U.S. Bancorp suffered lower than median declines in their net margins in this doomsday scenario. While Truist Financial suffered slightly worse.

(Source: Federal Reserve)

U.S. Bancorp and Toronto-Dominion essentially matched that of JPMorgan.

Now, Goldman Sachs (GS) estimates that as far as actual doomsday scenario, such as nuclear war with Russia, the odds are about 2% to 2.5%.

Now, since we'd all be too dead to care if this actually happened and bank portfolios and money likely wouldn't even exist, it's pretty fair to simply ignore this.

But now let's take a look here.

(Source: Federal Reserve)

Note that regulatory minimums for each bank are different.

This is based on the Fed's model estimate of how complex and important each bank's business is to the global economy.

Now, no bank failed to remain at or above regulatory minimums, even at the peak economic catastrophe of this doomsday scenario.

Truist Financial and U.S. Bancorp came close to hitting their minimums, but they still passed the test.

Now, overall, the banking system for the 23 largest banks has a leverage ratio of 6.25… Meaning that for every dollar in deposits, they're making $6.25 in lending.

This is compared to regulatory maximum of $6.90.

This leverage built into fractional reserve banking is why 85% of the U.S. money supply comes from banks.

Now, there didn't used to be any of these regulations before the Great Depression. That's when banks were running ten times leverage as a system. And of course, individual banks could go as high as 15 or 20 or even more.

That's why in the Great Depression, 30% of banks (9,000 of them) failed in about three years.

Now, I know what you're probably thinking, 6.25 leverage still sounds high.

And even that regulatory maximum of 6.9 sounds pretty dangerous.

And in fact, it would be, no broker will allow you personally to use seven times leverage with your portfolio.

Now, some hedge funds, such as Archegos Capital Management, can use things like options to get leverage that high.

And in fact, Archegos famously did have seven times leverage with no hedges.

But that's why they lost $32 billion in two days, got wiped out and cost the banking system in Europe about $8 billion in profits.

They're the ones who are funding these idiots.

Now, I'm sure you're wondering, what does that actually mean for our banking safety?

Well, 6.9 times leverage means that if banks ever suffered 16% loan losses, they would be wiped out and so would our economy.

So I bet you're wondering how bad do bank losses actually get?

And I'm not just talking about the average recession, I'm talking about a severe recession.

I'm talking about the Great Financial Crisis.

Well, you're in luck because you're rolling with myself, the dividends sensei and chart master supreme. And I have the answer.

As you can see, the highest loan loss rates ever recorded in modern times outside of the Great Depression were during the Great Recession at 3.12%.

(Source: St. Louis Federal Reserve)

Now, this means that with their 12 times leverage, the U.S. banking system lost about 36% of its equity because of high leverage in the Great Recession.

Now, under current regulations, the maximum they would have suffered is 21%.

And during the pandemic crisis, when loan losses peaked at 0.54%, actual banking losses under current regulations (which they were in place at the time) were 3.5%, or about 1/10 that of the Great Recession.

So basically, the U.S. banking system today looks fantastic.

Now, it's not necessarily Canadian banking safe. As I’ve described in the past, the Canadian banking system is the global gold standard.

They haven't had a banking crisis since 1840.

And in fact, since 1840, they haven't suffered a single bank failure, not even in the Great Depression – with the one exception – which was caused by outright fraud.

But the point is, U.S. banks are pretty darn safe and I'm not losing sleep over them, and neither should you.

Thank you for joining us for part one of our two part fantastically exciting and riveting look at the Fed U.S. Bank stress tests.

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.

And again, thank you for joining us this week and I hope you join us for next week when will conclude with part two of the exciting and thrilling conclusion to our 2023 banking stress test coverage.

I promise to bring the fire and make it sexy baby, because there's nothing sexier than safe money and growing dividends.

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

And of course, live long and prosper.