The Greater Financial Crisis of 2024

You’re probably aware that Fitch has downgraded the credit rating of the United States from AAA to AA+. It was big news last week.

That’s nothing to cheer about, though it’s not likely to have much impact on the markets in the short run. It’s more of a long-term problem.

But it’s certainly another straw in the wind showing that the U.S. is on a non-sustainable fiscal course that can only end in default, hyperinflation or protracted depression-level growth.

Meanwhile, another major credit ratings agency, Moody’s, has just issued its own downgrades that may foretell a much more immediate threat.

And they don’t involve the government.

Downgraded!

On Monday, Moody’s cut the credit ratings of 10 small and midsize U.S. banks, while placing six large banks on watch for potential downgrades.

The six large banks include Bank of New York Mellon, U.S. Bancorp, State Street and Truist Financial.

Moody’s has also lowered its outlook to negative for 11 major banks, including Capital One, Citizens Financial and Fifth Third Bancorp.

Here’s what Moody’s said yesterday:

Many banks’ second-quarter results showed growing profitability pressures that will reduce their ability to generate internal capital.

This comes as a mild U.S. recession is on the horizon for early 2024 and asset quality looks set to decline, with particular risks in some banks’ commercial real estate (CRE) portfolios.

It Won’t Be Subprime Mortgages Next Time

We all remember the Global Financial Crisis of 2007–08, which was allegedly caused by subprime mortgages in the residential real estate sector.

In reality, subprime loans played a role in the crisis, but they were more a symptom than a cause. The real cause was excessive monetary tightening by Ben Bernanke in 2006–07. With that as background, pundits are again looking at residential mortgages and inflated home values as a potential source of crisis.

But they’re looking in the wrong place.

Since 2009, conditions for mortgage loans have tightened considerably. A down payment of 20% or more is routinely required. Full documentation (tax returns, W-2s, employment verifications, title insurance, etc.) is necessary and co-signers are often required.

This does not guarantee loans don’t default, but there will certainly be far fewer defaults and larger owner equity cushions to absorb any losses. For warning signs this time, investors might do well to look at commercial real estate, as Moody’s downgrades indicate.

The Looming CRE Crisis

CRE is crashing on several levels. In the first place, valuations are falling and vacancies are rising, partly in response to the post-pandemic work-from-home movement and the general urban flight due to high crime and vagrancy.

At some point, owners are underwater on rents and just drop off the keys with the lender and walk away.

The other problem is that new building construction is not financed with long-term mortgage, but with short-term construction loans. I don’t want to get too deep in the weeds here, but it’s important to understand the basic dynamics.

These short-term loans have two- or three-year maturities. When the building is finished, the developer gets a long-term mortgage and pays off the construction loan in full. The difficulty arises when credit conditions charge materially between the time the project is started and when it is completed.

That’s exactly what happened in 2021 during the post-pandemic boom, and what will happen in 2024 when a lot of the construction loans are due.

If developers can’t get the long-term financing on favorable terms, that becomes another reason to walk away. Then you’re looking at a cascading crisis as the losses pile up.

“I Want My Money Back!”

Each financial crisis begins with distress in a particular distressed sector and then spreads from sector to sector until the whole world is screaming, “I want my money back!”

First, one asset class has a surprise drop. The leveraged investors sell the sinking asset, but soon the asset is unwanted by anyone. Margin calls roll in. Investors then sell good assets to raise cash to meet the margin calls. This spreads the panic to banks and dealers who were not originally involved with the weak asset.

Soon the contagion spreads to all banks and assets, as everyone wants their money back all at once. Banks begin to fail, panic spreads and finally central banks step in to separate winners and losers and reliquefy the system for the benefit of the winners.

Typically, small investors (and some bankrupt banks) get hurt the worst while the big banks get bailed out and live to fight another day.

That much panics have in common.

Fighting the Last War

What varies in financial panics is not how they end but how they begin. The 1987 crash started with computerized trading. The 1994 panic began in Mexico.

The 1997–98 panic started in Asian emerging markets but soon spread to Russia and the big banks. The 2000 crash began with dot-coms. The 2008 panic was triggered by defaults in subprime mortgages.

And the next panic might well be triggered by defaults in commercial real estate. Risk hasn’t gone away, it’s simply shifted.

But today the regulators are like generals who are fighting the last war. They’re too focused on the last war to know where the next one will begin or how to fight it.

They’ll be blindsided, along with most investors.

There’s Time to Prepare

Does that mean we’re going to see a crisis tomorrow? No, not necessarily. Both the panics of 1998 and 2008 began over a year before they reached the level of an acute global liquidity crisis.

Investors had ample time to reduce risky positions, increase cash and gold allocations and move to the sidelines until the crisis abated. At that point there were bargains galore for those with cash.

An investor with cash in 2008 could have preserved wealth during the crisis and nearly made six times his money since then by buying the Dow Jones index at 6,550 (it’s trading over 35,300 today).

Relatively few investors did this. Instead they suffered from “fear of missing out” as markets rose until the panic began. They persisted in the mistaken belief that they could “get out in time” if markets reversed, not realizing that reversals happen much faster than rallies. They held onto losing positions hoping they would “come back” (they did after 10 years) and so on.

Investors don’t need to worry about subprime home loans this time around. But they would do well to pay attention to the CRE space. That’s one canary in the coal mine of the next global financial crisis.

I advise you to plan accordingly.