Just Credit Raters Doing Their (Backward-Looking) Jobs

Editor’s Note: MarketMinder doesn’t make individual security recommendations. Any reference to a specific security in this article is merely incidental to our broader point.

Oh, credit raters. What would we do without them? However would we manage had first Moody’s, then Standard & Poor’s not downgraded several US regional banks this month, citing deposit outflows and rising borrowing costs? It isn’t like the banks themselves have reported all this on earnings calls. Or the Fed has reported deposit trends weekly. Or the whole doggone industry skated through several regional bank failures in the spring, drawing endless investor attention. Oh, wait, all of that happened—showing, once again, that credit ratings changes merely confirm what everyone already knew. They are backward-looking summaries, not actionable events for investors.

Considering the regional banking crisis unfolded in March as Silicon Valley Bank and Signature Bank failed—with a brief sequel in May as First Republic hit the skids and was eventually bought by JPMorgan Chase—this month’s downgrades probably seem like a belated box-ticking exercise. And, well, it is. That is sort of the business model here. Companies pay them to rate their debt, and since credit raters don’t have crystal balls or time-traveling machines, they basically report what has happened, guess at what that means for creditworthiness looking forward, and translate that to a letter grade.

But this means credit rating decisions generally encompass things everyone already knew. S&P cited earnings headwinds in several of its regional bank decisions this week. But this just rehashes everything banks reported in their Q2 earnings calls—the falling net interest margins, rising borrowing costs and increased reliance on wholesale funding we highlighted when we rounded up regional bank earnings last month. And all those earnings calls did was put some numbers to the trends everyone identified in Fed data and interest rates … trends markets had already priced in, judging from the returns of regional banking ETFs.^[i]

Those same markets don’t seem to see new headwinds above and beyond what everyone identified in the spring. Consider bond markets. After spiking around March’s regional bank fears, the difference in US bank yields versus Treasurys has declined from 2.03 percentage points to 1.46, near levels seen throughout 2022.^[ii] These spreads are a key way to gauge perceptions of risk. Investors are demanding much less of a premium to lend to banks than they were at the crisis’s heights. And make no mistake, they are lending: Financials’ globally have upped bond issuance by 6% year to date versus the same period in 2022. Now, this includes banks of all sizes from everywhere—not just US regional banks. But if regional banks were truly badly off and contagion were a proper risk, which was the big fear this spring (and which the downgrades imply remains a risk), investors would probably be much more gunshy toward the sector overall.

We don’t begrudge raters their opinions. And, again, this is what regulations require (and issuers pay them) to do. It is their job. It is a government-choreographed song and dance, ensconced in laws and regulations dating back to the 1970s. But when it comes to making investment decisions, we think it makes more sense to incorporate raters’ decisions in the sentiment side of the equation. Include them in your assessment of what everyone sees and deems likely, then weigh the likelihood that reality goes better or worse than that. In terms of regional banks potentially roiling lending and the economy, we see plenty of room for reality to continue exceeding expectations.