Moody’s breaks the banks

Stocks surged yesterday as investors repositioned themselves in the wake of last week’s lackluster performance. Things are about to get dicey in the banking sector with surprise Moody’s downgrades.

Third verse, same as the first. Remember that mini-banking crisis from last March? You know, the one where some well-established, long-heralded institutions literally crumbled before our very eyes. They were gone in a flash… er, a weekend. In any other time, the catastrophe may have sent negative shockwaves across the globe causing a major setback. However, in the wake of abysmal market performance in 2022 combined with the Fed’s wait-and-see stance, markets kind-of shrugged the whole thing off.

Following SVB Financial’s collapse, it seemed that everyone knew it was coming… even the Fed, whose job it was to oversee the bank. I know Wall Street didn’t invent the adage about “20/20 hindsight”, but this was one of those applications of it. In reality, it really was quite clear the SVB was suffering a bit as its target client base, the Silicon Valley venture community, was going through a rough patch. Loans were down and depositors were withdrawing capital at an alarming rate to keep their businesses afloat. All that was made worse by rapidly rising… um, rapidly risen short-term rates. With a few more minor details, the rest is history. SVB was the so-called first domino which sent another few banks tumbling. The Fed along with some larger banks managed to stop a broader chain reaction, significantly minimizing potential damage. The banks which did not make it all had the same hallmarks as SVB. Based on their profiles, they seemed destined for trouble. A major crisis had been averted… for the moment.

Besides, fickle Wall Street had another muse to tap into, viz Artificial Intelligence. Slowing inflation and a slightly-less-angry Fed fueled a narrow tech rally which left the banking sector to lick its wounds without further market punishment. The S&P500 Banks Index fell by some -25% from its height in February through its low in early May but has since recovered by around +19%. Don’t mess around with the math so early in the day, I will tell you that the Index is far from reaching its Feb high. The Banks Index to which I refer includes both larger and regional banks. If we narrow our view to more vulnerable regional banks, the earlier-in-the-year declines were far steeper with the KBW Regional Bank Index declining by -37% from its 2023 high to low. It too has had a bit of a recovery since bottoming in May. We are in the middle of earnings season and most of the banks have already reported Q2 results, which were not noteworthy in either direction. The badly managed balance sheets and fleeting deposits that caused banks to fail earlier in the year appeared to have been dealt with and low earnings bars were being met or exceeded. Unfortunately, there was very little mention of loan risk or tightening credit conditions.

I have written on multiple occasions about how regional banks have an outsized amount of commercial real estate (CRE) loans outstanding. I have also reported how more and more CRE investors are simply choosing to “turn in keys” rather than holding on to failing investments. Why are those CRE investments failing? Because companies are downsizing office space in an effort to save money. The pandemic showed them that they could live with less regardless of whether they are fully back to office, WFH, or hybrid. As lease terms come to an end, companies are looking for less space. The result is growing vacancy. Investors rely on rent receipts to make loan payments and with the former rapidly diminishing, they are faced with a dilemma: pay off the loan with cash or FedEx the keys to the bank, and more and more investors are choosing to relinquish the properties. This is a huge burden on the banking industry, but the challenge is only intensifying. Many CRE loans will be maturing in the coming 48 months, all of which will need to be refinanced at significantly higher rates than their predecessors. Higher rates mean bigger debt service which makes the challenge of diminishing rent rolls an even bigger problem. And this “bigger” problem will fall squarely on the small and mid-sized regional banks that hold a good portion of outstanding CRE debt.

Enter Moody’s Investor’s Service, who with perfectly clear hindsight, just last night said that it may downgrade a bevy of banks including US Bancorp, Bank of New York Mellon, and State Street, to name just a few. Moody’s did cut ratings on M&T Bank, Webster Financial, Old National Bancorp, and Pinnacle, along with others. It also put a “negative” outlook on PNC Financial, Capital One, Citizens, Regions Financial, Fifth Third, Ally Financial, Huntington Bancshares, and Bank OZK. There are other banks which are still under review, according to the rating agency. Note: This is breaking news, which is still unfolding, so check closely with Moody’s if you are concerned about stocks that you may own. Moody’s reasoning for the negative move is exposure to CRE loans and higher funding costs which will have a negative impact on income and intensify the challenge. Now, I am sure we can say that we saw this one coming, but that won’t help in dealing with this surprising overnight development which will surely impact the banking sector in the upcoming trading days. Stay focused and work on improving your foresight because we all have perfect hindsight.

STOCKS ON THE MOVE

International Flavors & Fragrances Inc (IFF) shares are down by -22.68% after the company missed earnings and revenues by a wide margin. The company also cut its full-year guidance stating that a 2H recovery was no longer expected. Dividend yield: 4.02%. Potential average analyst target upside: +26.08%.

Eli Lilly & Co (LLY) shares are higher by +8.55% in the premarket after it announced Q2 and raised its full-year guidance beyond analyst estimates. The company credits weight loss jab Mounjaro’s strong performance in contributing to the oversized return. Dividend yield: 0.99%. Potential average analyst target upside: +4.8%.

S&P500-listed banks Comerica, Citizens Financial, US Bancorp, Huntington Bancshares, Truist, Fifth Third, Bank of New York, Capital One, Bank of America, PNC Financial, Regions Financial, Zions Bancorp, Wells Fargo, Citigroup, and JP Morgan Chase are all lower in the premarket due to the unfolding Moody’s news reported above .

Also, this morning: AMC Entertainment, Aramark, Horizon Therapeutics, Zoetis, Warner Music Group, and TransDigm all beat on EPS and Revenues while UPS, SeaWorld, Duke Energy, Jacobs Solutions, and NRG Energy disappointed.

YESTERDAY’S MARKETS

NEXT UP

• NFIB Small Business Optimism (July) beat estimates and came in at 91.9, higher than June’s 91.0 print.
• Fed speakers today: Harker and Barkin
• Earnings after the closing bell: iRobot, Lyft, Bumble, Rivian, Rocket Lab, Luminar, Twilio, Coupang, and Topgolf Callaway.