Why is the market so disappointed with the US banking industry when it has been given a "red light" by rating agencies?

According to the Zhītōng Finance APP, after the regional banking crisis in the United States in March this year, bank stocks have been rising from May to July. However, the warnings issued by the three major rating agencies in August regarding the US banking industry have dampened the upward momentum of bank stocks, with the KBW Bank Index falling 8.77% last month.

In early August, Moody's downgraded the ratings of 10 US banks and warned of possible further downgrades, citing challenges such as rising interest rates, potential economic recession, and funding costs in the US banking industry. Shortly thereafter, Fitch also issued downgrade warnings, stating that "the US banking industry is gradually approaching another source of turmoil, with dozens of US banks at risk of rating downgrades, including large banks such as JPMorgan Chase."

Standard & Poor's also updated the ratings of 10 US banks later in August. Among them, the credit ratings of 5 US regional banks were downgraded by one level, and the rating outlook of 2 banks was adjusted to "negative." Standard & Poor's stated in the rating announcement that since March 2022, the Federal Reserve's significant interest rate hikes and quantitative tightening measures to combat high inflation have put pressure on the financing, liquidity, and interest spread income of many US banks, leading to a possible decline in bank asset values and deterioration in asset quality.

Despite strong signs of the US economy, the market remains disappointed with US banks, especially regional banks. Data from Morningstar shows that the SPDR S&P Regional Banking ETF, which tracks regional banks under S&P, has fallen 25% year-to-date, the worst performance since records began in 2006. In the month ending September 8 (when Moody's downgraded the ratings of 10 US banks on August 7), the ETF fell 10%.

Jill Cetina, Deputy Managing Director of Moody's US banking industry, said that the issue is not only about the next steps for bank stocks but also about whether banks can fulfill their role of providing credit to other sectors of the economy. Their medium-term fate will largely depend on external factors, from whether the Federal Reserve will cut interest rates next year to how quickly employers have been pushing for a return to work in recent months.

However, the most critical question is whether the economy will experience a recession in early 2024 as Moody's predicts, exacerbating credit problems and reducing bank asset values. Jill Cetina pointed out that a survey of bank loan officers by the Federal Reserve shows similarities to the situation before the economic recessions of 2007 and 2000, when many banks raised credit prices and tightened loan standards. She said, "Banks play a crucial role in shaping macroeconomic outcomes."

Now, the outlook for the US economy is much better than before. Many investors and economists believe that the possibility of an economic recession is much smaller than what was believed six months ago. For example, Jan Hatzius, Chief Economist at Goldman Sachs, stated, "First, against the backdrop of steady employment growth and rising real wages, US real disposable income in 2024 seems likely to reaccelerate. Second, we still strongly disagree with the view that the increasingly severe drag from 'long and variable lags' in monetary policy will push the economy into a recession." According to reports, this is the second time in nearly two months that Goldman Sachs has lowered the probability of a US economic recession. In July, Goldman Sachs cited slowing inflation as the reason for reducing the likelihood of a US economic recession in the next 12 months from the previous forecast of 25% to 20%. In addition, Jan Hatzius' estimate of a 15% probability of an economic recession is much lower than the market's general expectation of 60%.

The debate about the fate of banks mainly revolves around two things: interest rates and real estate (especially commercial real estate). Although some Federal Reserve officials have expressed their willingness to continue raising interest rates, surveys show that many investors believe the Federal Reserve will start cutting rates before spring next year as inflation subsides. In addition, in terms of commercial real estate, some analysts believe that although office vacancy rates will remain high and may force more developers to default, this has not been reflected in the second-quarter earnings reports of banks.

1. Interest Rates

Rating agencies such as Moody's have pointed out that rising interest rates threaten banks' net interest income, which is a source of bank profits, and their ability to make long-term loans. In fact, compared to the first quarter, most banks' interest income declined in the second quarter. Alexander Yokum, a banking stock analyst at CFRA Research, said the decline in the third quarter will be even greater, and so will the net interest margin.

However, those who are bullish on bank stocks point out that although high interest rates have eroded bank profits since the second quarter, the impact on most banks has been minimal so far. Several banks have stated that rising interest rates over the past year have boosted profits; at most banks, net interest income and net interest margin in the second quarter of this year were better than in the second quarter of 2022.

Morgan Stanley analysts Manan Gosalia and Betsy Graseck also pointed out that deposits at most banks increased at the end of the second quarter, even including regional banks that were considered vulnerable to deposit outflows. This dispelled concerns about banks significantly raising deposit rates to retain customers. Data shows that the average deposit rate for Wells Fargo in the second quarter was 1.13%, and for Bank of America, it was 1.24%.

2. Credit Quality

Alexander Yokum said that the credit quality of most lending institutions has deteriorated but is still better than pre-pandemic levels, and even the office industry has shown little sign of serious problems.

Take Valley National Bancorp (VLYPP.US), Commerce Bancshares (CBSH.US), and Zions Bancorporation (ZION.US) as examples, which have had their ratings downgraded by rating agencies. Valley National Bancorp has $50 billion in loans on its balance sheet, of which $27.8 billion comes from the commercial real estate industry, a proportion much higher than Bank of America's 7%. However, office loans account for only 10% of these commercial real estate loans, less than 6% of the total loans.

Data disclosed by Valley National Bancorp shows that as of the end of June, its total non-performing assets amounted to $256 million, accounting for only about 0.5% of its total loans. The bank also believes that the write-off amount for loans that cannot be fully repaid decreased in the second quarter, with its $460 million loan loss provision nearly double the amount for all problem loans.

During the second quarter, Zhiang Bank's $2 billion office building investment portfolio did not have any delinquent loans. This portfolio is part of the bank's commercial real estate exposure, accounting for more than a quarter of its assets. Additionally, Commerce Bancshares has a similar situation to Zhiang Bank.

Many banks believe that the bearish view overlooks the fact that they have issued very few loans for office buildings, thus exaggerating the problem of real estate loans. Banks argue that the occupancy rates for hotels and warehouses are high, and although the office building portfolio faces significant risks, the size of the office building loans is too small to threaten the banks' health.

3. Two Major Issues Facing the Banking Industry

Eight months have already passed this year, and it is expected that nearly a quarter of office building loans will mature and require refinancing at current higher interest rates. However, the loan write-off rates for almost every major bank are still below 1%, and this situation is becoming increasingly common. Will soaring house prices arrive soon, or have banks postponed the liquidation of short-term financing in the hope of lower interest rates or higher occupancy rates? Additionally, when will more employees return to the office, thereby alleviating the pressure on rent due to reduced office space for businesses?

Jan Hatzius, Chief Economist at Goldman Sachs, pointed out that the proportion of U.S. employees working from home for at least part of the week has stabilized at around 20%-25%, lower than the peak of 47% in 2021 but much higher than the pre-pandemic level of 2.6%. Goldman Sachs stated that as companies like Amazon become increasingly demanding for employees to return to the office, remote work is expected to increase office vacancy rates by 3 percentage points by 2030, but this impact will be mitigated by the almost halt in new construction projects.

These findings have led some market participants to speculate that the bottom may be approaching. Trevor Adler, a real estate lawyer in Manhattan, has observed growth in the real estate market, such as long-term leases being signed by public sector tenants like Empire State Development, which is uncommon in July.

Ben Miller, CEO of real estate investment online platform Fundrise, believes that the Federal Reserve and other banking regulatory agencies are encouraging banks to provide extensions or other assistance to borrowers who previously had the ability to repay. He stated that the main method the Federal Reserve is using to ease the upcoming wave of foreclosures is by lowering interest rates, allowing developers to refinance office buildings and maintain profitability. "If interest rates remain high for a longer period of time, then banks will be in big trouble. But if high interest rates are temporary, it will allow banks to enter a normal interest rate environment afterwards."