A Downgrade We Can Believe In

Moody's: 'Fitch, hold my beer'... A downgrade we can believe in... The banks at greatest risk... What 'higher for longer' does... The grip of recession... It's already happening faster than in the financial crisis...

Another day, another downgrade story...

When Fitch Ratings downgraded U.S. government debt a notch last week to AA+, I (Corey McLaughlin) looked at it mostly as a long-overdue conversation starter for the general public...

Last night, though, Moody's, another of the big credit-ratings agencies, got more specific with another round of credit downgrades. Moody's aimed specifically at certain U.S. banks that it said showed second-quarter results that "will reduce their ability to generate internal capital."

Uh-oh.

Said another way, the firm published warnings about potential trouble ahead for banks, naming names and reasons as if to say, "Fitch, hold my beer." As Stansberry NewsWire editor Kevin Sanford wrote this morning...

Moody's Investors Service downgraded the credit ratings of 10 small and midsize U.S. banks and said it's considering the possibility of downgrading major lenders such as U.S. Bancorp (USB), Bank of New York Mellon (BK), State Street (STT), and Truist Financial (TFC)...

Moody's cited several problems currently plaguing the banking sector, including high funding costs, potential regulatory capital vulnerabilities, and growing risks associated with commercial real estate loans due to diminishing demand for office space.

The downgraded banks include M&T Bank (MTB), Pinnacle Financial Partners (PNFP), and BOK Financial (BOKF).

Moody's also changed its current outlook to "negative" on 11 banks, including Capital One Financial (COF), Citizens Financial (CFG), and Fifth Third Bancorp (FITB). And it did so for reasons unlikely to surprise longtime Digest subscribers...

These banks have large exposure to subprime borrowers, who are likely the first to stop paying back their loans in a recession when times get toughest (which is still possibly ahead). And that spells bad news for these banks' profits ahead...

And when subprime lenders struggle, that means possibly choking off debt-fueled growth in wide swaths of the economy (you know, what the U.S. has known and loved for decades). If enough banks give up collecting on enough bad loans, or if more loans go bad than expected, the party could be over.

This is the kind of thing we mean when we say to prepare for the next "credit crisis" ahead.

Our team has warned about Capital One, specifically, over the years...

And, specifically, various folks at Stansberry Research have done so ahead of the type of economic conditions the U.S. is potentially facing again.

Going back to the financial crisis, our flagship Stansberry's Investment Advisory booked a 53% profit by shorting Capital One shares...

And in August 2022, Stansberry Research senior analyst Mike DiBiase and analyst Bill McGilton recommended subscribers of our Investment Advisory short the stock again – for essentially the same reasons Moody's is finally "negative" about the bank about one year later...

Nearly half of Capital One's auto loans and 30% of its U.S. credit-card loans are to subprime borrowers. That's a total of $73 billion worth of subprime debt. Yet the bank only has $12 billion reserved for loan losses across its entire $296 billion loan portfolio.

Let's assume all of those reserves are against its subprime loans... That leaves another $61 billion ($73 billion subprime debt less $12 billion in reserves) of unreserved subprime debt. That's nearly twice the size of its tangible equity.

We're not saying Capital One, or any other big bank for that matter, will go bankrupt in the next credit crisis. Banks are much better capitalized today than they were in 2008.

But as the recession deepens, Capital One's credit losses will be much larger, and it won't take long to erase much of the company's profits.

Mike and Bill went on to detail precisely how much the bank could eventually be on the hook for loans that go bad, something called "charge offs," which banks account for but are nonetheless significant to their business...

During the last two economic downturns, Capital One wrote off loans that went bad (called charge-offs) that amounted to 5% of its total loan portfolio in each of the two years following the start of the recessions.

Based on the current value of its loan portfolio, that means we can expect Capital One to write off around $15 billion in bad loans (5% of $296 billion) each year over the next two years.

That would be enough to wipe out nearly all of the profits Capital One might generate, they said, crushing its stock price.

So, back in August 2022, Mike explained why shorting Capital One was a great hedge for both a recession and a market downturn... In the financial crisis, the stock shed 85% of its value from early 2008 to its lowest point in March 2009. According to Mike and Bill...

Similar bad times are ahead for Capital One.

What 'higher for longer' does...

Now, stuff like this happens even in a "normal" credit cycle. Banks lend freely, subprime borrowers don't pay, and banks, smarting from their written-off loans, tighten their lending standards.

Today's environment has significant defining features, though, that separate it from the normal "tightening" stage of the credit cycle.

Remember, interest rates are the highest they've been in 15 years. As they soared from near 0% to past 5% in barely more than a year, it quickly hit consumers' budgets and banks' capital on hand.  

This was what the tech-crowd clients of Silicon Valley Bank and customers of other regional banks caught on to earlier this year... If you recall, they essentially went on anxiety-fueled online bank runs for fear of losing all their deposits when they realized the banks didn't have enough capital on hand.

And today, it seems everyone with an association to Uncle Sam is so scared of a recession that they'll do anything to prevent it – or will alternatively define it as they wish, as happened in the first two quarters of 2022. Remember, it's a salamander wearing a top hat.

But recessions happen – and will again...

The situation for subprime borrowers and the banks that lend to them will only get worse in the next "formal" recession...

I suspect this is probably why the Fed has "paused" rate hikes once this year and would love to again. But it also has to deal with that thing called high inflation that's already wrecking everyday Americans' lives...

In any case, in the view of Moody's, a tougher time for banks is likely ahead. The firm wrote in its report that has (rightfully) made headlines in the past 24 hours...

We expect banks' [asset-liability management] risks to be exacerbated by the significant increase in the Federal Reserve's policy rate as well as the ongoing reduction in banking system reserves at the Fed and, relatedly, deposits because of ongoing [quantitative tightening]...

Interest rates are likely to remain higher for longer until inflation returns to within the Fed's target range and, as noted earlier, longer-term U.S. interest rates also are moving higher because of multiple factors, which will put further pressure on banks' fixed-rate assets.

We can't say for sure that it will play out like this. But Moody's is forecasting a mild recession in early 2024 and says it believes "there will likely be a tightening of credit conditions and rising loan losses for U.S. banks." This is the heart of the matter...

When banks are left with their proverbial palms up in the air for delinquent loans, they write off billions (in the case of Capital One) and are less likely to make future loans they might otherwise... stunting more economic growth.

This is the point when the Fed typically steps in and lowers rates – and in recent history, has added to its balance sheet – to make financial conditions easier for everyone involved.

Of course, that was back when high inflation wasn't a leading public concern. That's hardly the case today. Banks could be in for more trouble – for longer – than many people might expect... which could keep lending tight for longer than people expect, too. Take note.

This situation is already getting rough...

Our Investment Advisory team just updated subscribers on its short position in Capital One in this month's issue of our flagship publication, published last week... Just as Mike and Bill expected, Capital One has been quickly running into trouble...

Capital One is writing off more bad debt today − and at a faster pace − than during the last financial crisis. The bank's charge-offs (bad loans the bank has given up on collecting) totaled $2.2 billion last quarter, up from $845 million a year ago.

This bad debt as a percentage of Capital One's loans (known as its charge-off rate) has more than doubled over the period, from 1.18% to 2.82%. And it's headed much higher.

Keep in mind, we're not even in a widely recognized recession.

I don't think it's a coincidence that the financial sector of the S&P 500 led the way down today, off about 1%, with banks like Fifth Third, Citizens Financial, and PNC Financial Services (PNC) off around 2% and among the day's biggest losers.

Now, a good chunk of the downside in Capital One may have already been realized. Shares fell 50% from their 2021 highs to a low this May as a higher-interest-rate era became more widely expected. And Stansberry's Investment Advisory is sitting on double-digit gains on the short position in its model portfolio. 

The bank's shares are actually up more than 20% since the start of the year... But they were off 0.6% today, are below their highs from February, and have gone mostly sideways the past two months at around $114 per share...

Our team's short recommendation remains an open position in the model Investment Advisory portfolio.

Please note, though, we don't suggest anyone go about blindly shorting this or any stock. Existing subscribers and Stansberry Alliance members can find Mike and Bill's original recommendation and instructions here. They can also find the latest Investment Advisory issue here with the full update on Capital One and other portfolio holdings, plus a brand-new recommendation from Stansberry Research senior analyst Alan Gula.

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And it's the perfect time to try the Investment Advisory...

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New 52-week highs (as of 8/7/23): Berkshire Hathaway (BRK-B), CBOE Global Markets (CBOE), CME Group (CME), Dice Therapeutics (DICE), Comfort Systems USA (FIX), Fortive (FTV), Gambling.com (GAMB), Ingersoll Rand (IR), Oshkosh (OSK), Parker-Hannifin (PH), PulteGroup (PHM), Ryder System (R), TFI International (TFII), Trane Technologies (TT), Textron (TXT), and Walmart (WMT).

In today's mailbag, feedback on rising gas prices and declining unemployment, which we wrote about in yesterday's Digest, and more comments on Dan Ferris' latest Friday essay... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"Why won't they open our gas back up? Are they stupid or just plain crooked?" – Subscriber Judith C.

"I find it puzzling we talk about the 'low' unemployment rate when we have the lowest [labor force participation] rate in history at around 61%. [Editor's note: It's at 62.6%, a number last seen in 1977.] What would be the unemployment rate if we had a normalized labor participation rate? The economy is looking pretty weak." – Subscriber Mike O.

"I agree that Dan's point in Friday's Digest, regarding time as having significant import in our physical world, is profound. Scientifically, what Dan is describing is the effect of entropy. Entropy is inherent in the second law of thermodynamics. Entropy is the phenomenon that governs our physical world, where systems go from order to increasing disorder unless energy/work is focused on stopping or reducing the disorder." – Subscriber Peter A.

All the best,

Corey McLaughlin
Baltimore, Maryland
August 8, 2023