2023-08-23 11:15:02 ET
Summary
- On Tuesday, S&P Global downgraded the credit ratings on 5 U.S. regional banks.
- The ratings agency also lowered its outlook for several others on concerns regarding the lending environment.
- The action echoes a similar move by Moody’s earlier in the month.
- KRE ETF has slumped over the past month on broader banking fears.
- Despite the heightened level of risk, the sector appears stable.
Heading into the Q2 earnings season, market sentiment on the regional banks was understandably bearish. High-profile failures in Silicon Valley, Signature, and First Republic earlier in the year had many expecting the worst, deposit flight a prime fear.
Ultimately, the worst didn't materialize. In fact, many performed surprisingly well. Components of the SPDR S&P Regional Banking ETF ( KRE ), such as M&T ( MTB ), Western Alliance ( WAL ), and Zions ( ZION ), to name a few, all reported stable or higher deposits in Q2 compared to the first quarter.
Yet on Tuesday, some components of the KRE were downgraded by S&P Global Ratings on concerns regarding tough operating conditions. This sent the ETF down nearly 3% for the day, adding to the overall monthly losses of approximately 8%.
The negative sentiment is worth consideration, but markets may be overly bearish. In my view, Q2 results validated the health of many of the components in the KRE ETF. While risks remain, the worst has likely passed. For investors seeking portfolio diversification, KRE would make for a solid addition to any new or further weakness in price.
Which Regional Banks Were Downgraded By S&P Global?
Credit ratings were lowered for five regional banks, Comerica ( CMA ), KeyCorp ( KEY ), Valley National Bancorp ( VLY ), Associated Banc-Corp ( ASB ), and UMB Financial Corp. ( UMBF ).
Just one, VLY, is currently included within the top 10 holdings of KRE. And CMA and KEY, in fact, are not even included as part of the total ETF holdings, which currently numbers 140. The other two names, ASB and UMB, are included but are outside of the top 20, let alone the top 10.
The downgrade from S&P follows an earlier downgrade from Moody's on a different set of lenders. Among the names included on Moody's list are MTB, Pinnacle Financial ( PNFP ), BOK Financial ( BOKF ), and Webster Financial ( WBS ), to name a few. This downgrade was more impactful to KRE, considering PNFP's weighting as the second-largest holding.
Why Did S&P Global Downgrade These Regional Banks?
In general, the downgrades were due to the more challenging nature of the current operating environment. With rates expected to stay higher for longer, S&P sees further deterioration in asset quality as likely. They also view those with higher exposure to office loans at higher risk of deterioration.
On an individual basis, larger deposit outflows were seen as risks for CMA and KEY, while a greater reliance on brokered deposits and worsening funding metrics were the risk factors for both VLY and ASB. In UMB's case, capital ratios were seen as weak.
The kicker with S&P's downgrade, however, is that the agency assigned "stable" outlooks to all five of the banks. This suggests the banks won't be cut again, at least in the near-medium term. Additionally, they also highlighted the improvements seen in the overall sector and cited strong earnings and lower-than-feared deposit outflows.
This contrasts with the commentary in Moody's downgrade two weeks earlier. In their note, they alluded to the prospect of a recession in early 2024 and its impact on loan demand and resulting defaults. In a note to The Wall Street Journal, Moody's Associate Managing Director, Jill Cetina, stated that they're seeing more funding and deposit pressure in the U.S. banking system than they've seen in a long time.
Still, even with the downgrade, all banks covered in Moody's note remain investment-grade rated.
Outlook For KRE's Largest Holdings
KRE's top 10 holdings represent approximately a fifth of the total ETF's stock basket, with each holding accounting for approximately 2%.
As expected, the top 10 have been on the decline over the past five days, with Zion and VLY bearing the brunt of the selling pressure, down over 5%.
VLY was among those in S&P's recent downgrade. But their outlook was rated as stable. And while the bank does have higher exposure to commercial real estate, their average loan size is below the peer average. These considerations recently earned the stock an upgrade from analysts at JPMorgan ( JPM ).
WAL and PNFP were two that were subject to an earlier downgrade from Moody's. In WAL's case, they received a two-notch downgrade on concerns regarding deposit outflow. In their note, Moody's attributed an 11% deposit outflow in the first quarter of the year to the fact that more than half of their deposits were uninsured at the end of 2022. However, the lender hit back in Q2 with better-than-expected results. PNFP was another that allayed fears in their Q2 results, reporting growth in loans and deposits of 11.3% and 17.1%, respectively.
The outlook is similar elsewhere. While profitability is expected to be down due to higher deposit costs, the worst-case scenario in deposit flight hasn't materialized. And it's unlikely it will, considering all the banks that were recently downgraded either still maintain investment-grade ratings or have been marked with stable outlooks.
How May Rising Interest Rates Impact KRE?
The regionals could be at greater risk if interest rates continue to rise. Higher deposit costs would be one risk factor. Those with greater holdings of commercial real estate ("CRE") loans could also be at further default risk when the loans ultimately come due.
In their Q2 results, PNC's ( PNC ) net charge-offs for their CRE loans soared to +$87M from +$10M last quarter and just +$4M in the same period last year. Looking ahead, CFO, Robert Reilly, noted that their office category continues to be a key area of concern. CEO, Bill Demchak, added that the category would still have trouble even in the event of a soft landing.
In addition to higher deposit costs and risks relating to CRE, higher mortgage rates carry risks for the regionals as well, namely through the diminished value of their longer-term fixed rate holdings. This was one of the biggest problems for First Republic that contributed to their demise.
On mortgage risk, there would also be simply less demand from borrowers. With rates recently hitting 20-year highs, those in the market are understandably hesitant to make any moves relating to a new or existing mortgage.
Is KRE A Buy, Sell, Or Hold?
The series of downgrades on a basket of regional banks by both Moody's and S&P is notable. And more could be coming. Fitch recently warned that it could be forced to downgrade dozens of U.S. lenders.
The ratings actions are important because banks fund themselves in part by selling bonds. A loss of confidence, then, could wreak havoc on the sector, as already has been seen earlier in the year.
But despite the recent actions, the outlook on the banks was maintained at "stable" by S&P. And those on Moody's list retained their investment-grade ratings. Q2 results also provided more concrete support on the health of the sector, namely in allaying concerns on deposit flight.
A higher for longer rate environment creates risks. Depositors could be more inclined to pull funds if rates hang around at current levels. A number of office operators could also begin to default as their debt begins to mature. And higher mortgage rates could create insurmountable pressure on the value of longer-term loans. More equity capital via higher capital requirements is one backstop for bondholders. But it's not necessarily the most accepted solution.
Given the risks, some may find it best to shy away from the sector altogether, but I believe that would be a mistake. A diversified ETF, such as KRE, provides an adequate way to gain exposure at a medium level of risk. Many of the components reported better-than-feared Q2 results and paired their prints with guidance that already factors in a rate environment that is higher for longer. The risks, therefore, are already priced in, in my view. Down 30% in the last six months and 8% in the last 30 days, KRE appears due for a course correction higher.
For further details see:
S&P Downgrades 5 Regional Banks: What Is The Outlook For KRE?