Here's How 5 Warren Buffett Stocks Would Perform in a Severe Recession

Warren Buffett and his company Berkshire Hathaway own many bank stocks, which make up a large part of Berkshire's roughly $317 billion equities portfolio. Banks are cyclical and tend to be tightly linked to the economy, which, if you haven't heard, may well be in a 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 largest banks in the country through a set of hypothetical adverse economic scenarios to see how they would hold up. This year, banks were put through a scenario in which unemployment would rise 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 stock prices would also fall 40% and 55%, respectively.

Stress testing is important for banks because it helps determine how much regulatory capital they must hold, which in turn determines how much capital they can return to shareholders through dividends and share repurchases. 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 new capital return plans on June 27.

As expected, all banks put through the exercise passed, maintaining enough capital to absorb loan and trading losses and still be able to lend to individuals, families, and businesses during a severe economic downturn. Let's look at how Buffett's bank stocks fared on an individual basis.

1. Bank of America

Bank of America (BAC -3.39%) is Berkshire's second-largest holding in its portfolio, making up roughly 10.5%.

A big way that the Fed and investors evaluate capital is through the common equity tier 1 (CET1) capital ratio, a measure of a bank's core capital expressed as a percentage of its risk-weighted assets such as loans.

Bank of America, the U.S.'s second biggest bank with $2.5 trillion in assets, would see its CET1 ratio of 10.6% at the end of 2021 fall to 7.6% under the severely adverse scenario, which is still well above the bare-bones requirement of 4.5%.

However, during the nine-quarter stress period, Bank of America would end up taking a loss before taxes of close to $44 billion, which was actually the highest of any bank tested. It would incur $52.5 billion of loan losses, which is equal to 5.2% of its total loan portfolio, and almost $13 billion of trading and counter-party 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 also severely dinged up commercial and industrial (C&I) loans, which are made to businesses for working capital or capital expenditure needs. The bank would see $17.4 billion of C&I loan losses in the Fed's hypothetical scenario.

The silver lining is that Bank of America can withstand an enormous amount of losses and still maintain reasonable capital levels. But the Fed's test was more adverse this year and could result in higher regulatory capital requirements for the bank, and therefore smaller capital returns.

2. American Express

The large credit card lender and payments company American Express (AXP -0.25%) is the fifth-largest holding in Berkshire's portfolio, at 6.8%.

The company performed very well in this round of stress testing. AmEx started the stressed period with a 10.5% CET1 ratio, only saw it fall to 9.9% (which is more than double the 4.5% requirement), and then ended the period at 12.5%, higher than what it began with.

Perhaps even more impressive is the fact that during the nine-quarter period, while AmEx would incur about $14 billion of loan losses, it also would be able to generate a pretax 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. U.S. Bancorp

U.S. Bancorp (USB -1.22%) , with $573 billion in assets, is another fairly big position in Buffett's portfolio, at 2.1% of Berkshire's total holdings.

The bank also managed capital very well through the severe scenario. It began with a 10% CET1 and only hit a low of 9.3% before rising back to 9.8% by early 2024. The bank would incur more than $18 billion in loan losses, almost 6% of total loans, in the period and end up with just a slight loss in the period.

U.S. Bancorp has long managed credit prudently through a number of difficult environments, which is why it trades at the strong valuation it does. After the sell-off this year, it also has a dividend yield of almost 4%, which is likely one of the reasons Buffett likes the stock so much. I'm sure the Oracle of Omaha wouldn't hate to see that dividend keep marching higher.

4. Citigroup

As one of the new additions Buffett made in the first quarter of this year, Citigroup (C -1.91%) makes up less than 1% of Berkshire's portfolio. But Berkshire hadn't invested in the bank since 2001, which makes it interesting, especially considering the discount Citigroup trades at.

During the stressed scenario, Citigroup would see its CET1 ratio fall from 12.2% to a low of 8.6% before rebounding to 9.5%. During the period Citigroup would take more than $43 billion of loan losses, the bulk of which would come from its large credit card business. The bank would also see another $13.6 billion of trading and counterparty losses on its way to a pretax loss of almost $27 billion.

The largest banks like Bank of America and Citigroup -- with more sizable credit card and commercial lending operations, as well as large investment banking businesses -- are going to take bigger hits than other banks in this kind of stress testing. 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 hypothetical scenario.

5. Ally Financial

Another new position for Berkshire in the first quarter, Ally Financial (ALLY -1.37%) runs a large digital bank focused on auto lending, making it a bit different than the other banks above. The stock only makes up 0.10% of Berkshire's portfolio.

Ally performed solidly in the Fed's stress test. Its CET1 ratio started at 10.3% and then fell to 8.9%, which is where it would also end in the first quarter of 2024. This branchless bank would incur about $7.8 billion of losses, mostly from auto loans, and would end up losing about $1.9 billion before taxes at the end of the period.