Warren Buffett and company Berkshire Hathaway own numerous bank stocks, which make up a large portion of Berkshire’s equity portfolio of about $317 billion. Banks are cyclical and tend to be closely tied to the economy which, if you haven’t heard, could well be in recession at some point this year or next.
Luckily for bank investors, the Federal Reserve recently released the results of its annual stress tests, which put the nation’s largest banks through a series of hypothetical adverse economic scenarios to see how they would hold up. This year, the banks were subjected to a scenario in which unemployment would increase and peak at 10.3% between the fourth quarter of 2021 and the first quarter of 2024. During this scenario, encompassing nine quarters, commercial real estate and share prices would also fall 40% and 55%, respectively.
Stress tests are important for banks because they help determine the amount of regulatory capital they must hold, which in turn determines the amount of capital they can return to shareholders through dividends and buybacks. of shares. Banks return capital to shareholders based on the excess amount they have above their regulatory requirements. Banks are expected to announce their new regulatory capital requirements and capital return plans on June 27.
As expected, all banks subject to the exercise were successful, retaining enough capital to absorb loan and transaction losses while still being able to lend to individuals, families and businesses in the event of a severe economic downturn. Let’s look at how Buffett’s banking stocks have performed on an individual basis.
1. Bank of America
Bank of America (BAC 0.72%) is Berkshire’s second largest holding in its portfolio, representing approximately 10.5%.
The Fed and investors largely assess capital through the Common Equity Tier 1 (CET1) ratio, a measure of a bank’s capital base expressed as a percentage of its risk-weighted assets. such as loans.
Bank of America, the second-largest bank in the United States with $2.5 trillion in assets, would see its CET1 ratio of 10.6% at the end of 2021 fall to 7.6% in the severe adverse scenario, which remains well above the minimum requirement of 4.5%.
However, over the nine-quarter stress period, Bank of America would end up with a pretax loss of nearly $44 billion, which was actually the highest of any bank tested. It would suffer $52.5 billion in loan losses, or 5.2% of its total loan portfolio, and nearly $13 billion in trade and counterparty losses.
Bank of America is one of the largest commercial lenders, so a 40% drop in commercial real estate prices would hit it hard, but the Fed scenario has also severely eroded commercial and industrial (C&I) lending, which are granted to businesses for working capital or capital expenditure needs. The bank would see $17.4 billion in losses on C&I loans in the Fed’s hypothetical scenario.
The silver lining is that Bank of America can sustain a huge amount of losses while maintaining reasonable capital levels. But the Fed’s test has been worse this year and could lead to higher regulatory capital requirements for the bank, and therefore lower returns on capital.
The leading credit card lender and payment company American Express (AXP 3.18%) is the fifth largest holding in Berkshire’s portfolio, at 6.8%.
The company performed very well during this round of stress tests. AmEx started the stress period with a CET1 ratio of 10.5%, only saw it drop to 9.9% (which is more than double the 4.5% requirement), then ended the period at 12.5%, higher than it had at the start.
Perhaps even more impressive is the fact that over the nine-quarter period, while AmEx would suffer approximately $14 billion in loan losses, it would also be able to generate a pre-tax profit of 5.1 billion, the second highest of the 33 banks tested. This should bode well for the bank’s regulatory capital requirements this year.
3. American Bancorp
American bank (USB 3.94%) with $573 billion in assets, is another fairly large position in Buffett’s portfolio, at 2.1% of Berkshire’s total holdings.
The bank also managed capital very well in the severe scenario. It started with a CET1 of 10% and only bottomed out at 9.3% before rising to 9.8% in early 2024. The bank would suffer over $18 billion in loan losses, i.e. nearly 6% of total loans, over the period and would end up with just a slight loss in the period.
US Bancorp has long managed credit cautiously in a number of challenging environments, which is why it is trading at the strong valuation it does. After this year’s sell-off, it also has a dividend yield of nearly 4%, which is likely one of the reasons Buffett loves the stock so much. I’m sure the Oracle of Omaha wouldn’t mind seeing that dividend continue to rise.
As one of the new additions that Buffett made in the first quarter of this year, Citigroup (VS 3.26%) represents less than 1% of Berkshire’s portfolio. But Berkshire hadn’t invested in the bank since 2001, which makes it attractive, especially given the discount Citigroup is trading at.
In the stressed scenario, Citigroup would see its CET1 ratio drop from 12.2% to a low of 8.6% before bouncing back to 9.5%. During the period, Citigroup would suffer more than $43 billion in loan losses, most of which would come from its large credit card business. The bank would also see an additional $13.6 billion in trading and counterparty losses en route to a pretax loss of nearly $27 billion.
Bigger banks like Bank of America and Citigroup — with larger credit card and commercial lending operations, as well as large investment banking firms — are going to be hit harder than other banks in this type. resistance tests. Similar to Bank of America, I wouldn’t be surprised to see Citigroup’s regulatory capital requirements increase, but overall the bank remained well capitalized during the what-if scenario.
5. Allied Financial
Another new position for Berkshire in the first quarter, Allied Financial (ALLY 4.96%) runs a large digital bank focused on car loans, which makes it a bit different from the other banks above. The stock represents just 0.10% of Berkshire’s portfolio.
Ally performed well in the Fed stress test. Its CET1 ratio started at 10.3% and then fell to 8.9%, where it would also end in the first quarter of 2024. This branchless bank would suffer about $7.8 billion in losses, mainly from auto loans, and would end up losing about $1.9 billion pre-tax at the end of the period.