How Sturdy are the US Banks and Private Equity Going into the Next Recession?

There is this new YouTube show that I started enjoying a fair bit.

You might know Steve Eisman from CNBC but people know him more as the guy being portrayed by Steve Carrell in the Big Short, which is a movie about the folks who realize the property & financial markets were unravelling before 2007/8.

I think he has more time on his hands so he decided to start a new show but I kind of like the format, and in this episode that I shared, we learn something about US banks. Steve brought along the people he turned to when he wishes to understand the banks better, Charlie Peabody and Brent Erensel from the boutique firm Portales Partners.

A Financial Crisis or Just a Bank Stock Correction?

They take us down memory lane to what happen before the Global Financial Crisis, and how the regulatory environment has changed since then. They also discuss how strong the banking sector is as a result and how they assess banks going into this recession.

While I know many of you don’t invest in US banks, there might be some who has some exposure via private equity, regional banks via US small cap value fund exposures that might find this useful.

The following are some of my notes.

Banking Industry before and after the Great Financial Crisis

1. Bank stocks emerge from the Dot Com bubble as a new leadership group.
2. However leadership breed excesses which lead to the Great Financial Crisis.
3. The banks manage to deleverage their balance sheets and the banks today are far more well capitalized compared to back then which gives Charlie Peabody confidence that if we were to enter a recession later this year, the banks will emerge okay.
4. After the Dodd-Frank Act was passed in 2010, it made the environment so complex. This became a fertile for the private capital companies to operate, but it hampered the banks. We are talking about companies like Blackstone, and Apollo.
5. The money from the zero interest rate policy all flow to the private equity business, side stepping the banking system. As a result, the banking system is currently very safe because the banks were not allowed to take any risks at all. However, you also have an underperforming group for 15 years.
6. The private equity companies were given free reign instead because of the lack of oversight, lack of market discipline. One of the things that regulators have tried in the last ten years is to put some restraints on this non-bank shadow lending banking system. But every time the hedge funds fought these transparency regulations successfully in the courts.
7. Then regulators tried to impose higher capital constraints by forcing the banks to put up more collaterals if they lend to private equity which results in higher lending rates. In 2023, they tried to bring these private equity firms under bank regulation and had they been successful, they would be able to impose greater lending constraints on them. That failed.
8. The vice-chairman of US banking financial supervision (2011 to 2016) increase the bank capital ratio to 14% when it was usually around 6-8%. The capital ratio is calculated by taking the equity divide by assets generally (aside from the complexities). Many bank chiefs including JPM’s Jamie Dimon thought that this would kill the banks. This reduces the bank’s return on equity (ROE) but made them more safe.

Why They Believe that Private Equity Could Potentially be the Next Epicenter of Financial Problems.

1. Charlie cites that current private equity has similarity to the Banking Panic of 1907.
2. In the last 3 years, private equity and credit was not able to monetize a lot of their investments. They hope that 2025 was the year that IPO and M&A were unleashed. What transpired currently have prevented them from monetizing this year.
3. What we are observing is many LP going to the secondary market to try and sell off their stake. They will be able to get only $0.93 of the $1 original value.
4. What we are observing is the same interlocking relationship formed like the interlocking trusts in the 1907. Blackstone is selling the asset to Apollo, who is selling the assets to Carlyle etc.
5. Charlie thinks that private equity and private credit will be the epicenter of the next dislocation.
6. The last bastion of liquidity that these PE and PC are going to are the pension funds and retail investors and we know when it reaches here, it is likely near the end game.
7. The Canadian pension plan have announced that they will be getting out of private equity.
8. Yale, Harvard and Princeton are saying they are selling private equity.
9. The Chinese government two days ago have prohibit their own funds from fulfilling their commitments to private equity. So basically although you told the funds you will commit capital, you are not doing it.
10. We are likely in an early innings of a liquidity drain that is likely to expose the overvaluation of their holdings.
11. The PE and PC are funded by banks and pension plans. If Trump decides to tax the pension plans, the pension plans will be reluctant to fund them. The banks will be reluctant to fund them. The private equity owns many companies which they levered up, mainly during the time when interest rate is very low. These loans have a tenure of 3-5 years and we might start to see stresses develop now. More of the PE’s companies may be on the brink of bankruptcies.
12. Charlie speculated that the transparency behind the debt is very poor so we don’t know just how bad is the situation.

Why Banks Today Are Sturdier than Our Impressions

1. If we are going into recession, credit losses is the most important metric that we should focus on.
2. When earnings start to lose visibility during challenging times, people start focusing on book value.
3. The question becomes whether we believe in that book value? Charlie believe that in this cycle the book value is believable.
4. In the past, the banks would trade as low as 40% of tangible book value. This cycle we may trade down to slightly below book value (est 90% of book value).
5. Charlie thinks that the banks will earn money (instead of living with losses like in the GFC) throughout this recession.
6. CECL Accounting (Current Expected Credit Losses) now allows banks to look ahead and build reserves. After the financial crisis, someone recommends the banks to consistently estimate upfront all your future losses and take that as your Loans loss provision. It used to be that people would use a 1% loans loss reserve but now there are more thought process into it. The banks can start from a conservative reserve, judge the operating landscape going forward, then add or subtract from the reserve. CECL is very draconian but it makes your bank balance sheet a lot safer. You access your loss exposure every quarter.
7. Charlies says the banks are much more healthy than they used to be. In bank disclosure, we will get an allocation of how the reserve is apportion for each type of credit. For example, we will know how much is for credit cards, and during recession the loss rates on credit cards can be quite substantial. Loss rates today are running between 3.5-5%, depending on your mix of customers. Banks today have typical reserves of about 7-8%, which is almost two years of losses in reserves. If we move into recession today and we get to the recession loss rates of 7-8%, they are currently pretty well prepared for that.
8. Brent added that having a healthy reserve now means that they won’t need to sell their assets to build up that reserve when the recession hits. This was the problem during the GFC because the banks would need to keep selling their assets to build up that reserves, which they had to take 2 years to do that. The lack of reserve batters your balance sheet/book value which is why banks sell at a discount to book value going/during recession.
9. This time, CECL Accounting may put banks ahead of the game instead of behind the game. This, together with what they have to do to adhere to Dodd-Frank have made what was previously a problem not very likely.
10. Charlie shared that Citigroup has a $2 trillion balance sheet with a $700 billion portfolio. The loans and commercial real estate is not a big part. The biggest portion is credit cards, and if we simulate recession stresses where the charge-offs doubles, Citigroup will still be profitable in his modelling. This is why he doesn’t think book value will be dented this time around.

Why Portales are Bullish on Banks in a Bearish S&P 500 Environment.

1. Steve ask if what they are saying is that the banks will be okay but in reality the markets work on a “proof it to me” basis, the banks will show that they make less money but will be unlike how they were in GFC and Portales Partners is not calling for a buy of the the banks currently. Portales recommends (Apr 7) to buy 33% of their position before earnings period. The banks did rally throughout the earnings because the announcement weren’t as bad.
2. Coming into this earnings period, there were talk of recession and stagflation. Credit was driving how the stocks were traded. We learn from the earnings announcement is non-performing assets was flat to down, charge-offs was not elevated compared to the previous 4 quarters, so credit was fine. In the commentary from the CEOs, we did not get the idea thinks were worsening into April. In fact, as the quarter progresses, we can see delinquency improve on the credit card side. This suggested that the consumer was not in a bad shape. Steve wonders why people would expect the bank numbers to look bad before recession happen.
3. Charlie explained why Portales decide to upgrade to a buy on banks on Apr 7. There were 3 things on the macro front that they focus on because macro will drive whether the US goes into a recession.
   1. We saw the “oligarchs” around Trump revolt.
   2. A bill moving through the Senate, sponsored by Chuck Grassley, which is to pull back the power of tariffs to the Congress. Trump was making use of his executive powers to enact the tariffs and so this will pull the power away from Trump.
   3. The plumbing of the banking system was starting to freeze. There is a risk of losing transparency in the banking system, the basis trade is starting to unwind.
4. All of these tell Portales that Trump will have to do something if not something will break and true enough, something was done. From this point, the sentiments can only get better in that what happened was the worst that could happen and anything else is a relatively better sentiments to this. Scott Bessent was becoming more prominent, even in the mind share of Trump while Lutnick and Navarro was featured less and less.
5. Portales think that we are going to have a steepening of the yield curve, which allows the banks to borrow at 3%, and lend at 6%. That was what the savings and loans institutions used to do before they went bankrupt. They think there will be a lower low in the S&P 500 by June because corporate earnings will be very poor, margins will get squeezed. From where we start the year, they see a cut in S&P 500 earnings of 5%, which we will have a EPS of $240 and if we apply a 20 times PE, that gets us close to 4800 on the S&P 500. Earnings would be flat this year, and if we apply a 18 times PE, that will get the S&P 500 to 4,320. This is just a bear market squeeze.

Charlie and Brent’s Favorite Banking Stocks

1. Citigroup for Charlie.
   • Apr 7 is at a deep discount to book value.
   • Thinks book value can grow to $96 per share and book value is real enough.
   • Jane Frazier is the first Citigroup CEO that will execute on her promises. Charlie did not bought into the turnaround stories of the previous three CEOs and did research pieces why their projections is not going to be met.
   • Jane is setting realistic goals to build five businesses and this is the first quarter that all five business show revenue growth. She is holding her lieutenants accountable which is non-existent prior. She is also simplifying the organization.
   • Citigroup will spin off their Mexican banking group Banamex in early 2026. Originally people think they could fetch 6-8 billion in valuation but from recent financials 10 billion may be possible. This will create a lot of financial flexibility so they can increase their capital buyback, which makes 2.5 billion in quarterly buy back likely. Since Citigroup is trading at a discount to book value and you are buying back shares, this is very accretive.
2. M&T Bank for Brent
   • A high quality regional bank in Buffalo with a strong franchise in New York and Mid-Atlantic area. They tend to do well in those blue collar regions while others are busy chasing the Sunbelt regions The bank is created by a legendary banker by the name Bob Wilmers but he has already passed away.
   • Brent thinks that M&T is an under the radar bank that has sailed through many credit cycles since the mid-80s.

Will There Be More Bank Mergers?

1. 2 previous Vice-chair of financial supervision have stepped down and we have a new Vice-chair of financial supervision under this Trump era.
2. Portales think that we are going to get multiple-expansion as a result of banking de-regulations.
3. However, on 18 Feb, Andrew Ferguson, the new chairman of the Federal Trade Commission (FTC), sent a memo to his staff stating that they are going to abide to the Biden-era approach to M&A activities. Portales look upon this as bearish for those stocks that will benefit from M&A activities and began recommending shorting them. The tariff uncertainty, and poor IPO outlook make this who environment a good area to short.
4. The deals that were blocked were deals that gave monopoly power and Charlie mentions in Trump era, he cannot have too many of these deals happening.
5. Steve points out that US did not have major bank M&A since the 1990s. He thinks that due to Dodd-Frank, the cost of regulations for the banks is much higher. The cost of technology is also much higher for banks. The big banks have gotten larger due to regulatory and tech costs. If he was in the shoes of a banking czar, he would want a bunch of banks that is capable of competing with the large banks. This may be a potential incentive for bank M&A.
6. Charlie think that there will be a flurry of deals between Memorial day (26 May 2025) to Labor day (1 Sep 2025) because by then, all the regulators will be confirm in their seats. Michelle Bowman has already been confirmed as the Vice-chair of Bank Supervision. Once these seats are more confirmed, CEOs will have more visibility to conduct M&A activities. We can point to how fast the Capital One and Discover deal was approved by the regulators as a source of confidence. If we go to 4,300 – 4,600 on the S&P 500 by June 2025, more deals is possible because everyone is waiting for prices to become better so that they can pounce on those deals. (Read Ten Reasons that Michelle Bowman Is the Wrong Choice to Lead Bank Regulation and Supervision at the Fed)
7. If Charlie were to be long, he would be focusing more on the regional bank side where the yield curve is likely to steepen.

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