Not a huge deal, but one to file away for May lest bank stakeholders get complacent after the recent stress test results.
We vaguely remember some people getting caught a little off guard when S&P downgraded a slew of banks last November because of a methodology change.
Well, recall that Moody’s announced a new ratings review of seventeen US and European investment banks last month, due to be released in mid-May — and the gang at Nomura have a feeling the agency will follow in S&P’s path with downgrades of its own.
And for a similar reason — that is, not because of anything to do with the stress tests or because of an actual shift in the banks’ risk profile but rather because…
… Moody’s just doesn’t think it is as good an industry as they did in the past and think the earnings volatility, sensitivity of wholesale funding, severe and unpredictable tail risks and less government support warrant an average “Baa” rating. …
For Global Capital Markets Intermediaries, Moody’s cites the following factors as the driver of ratings decline:
— Structural weaknesses persist: risk profiles that can quickly change and are prone toexcessive leverage, fat-tail risks and legacy of risk management failures, confidence sensitivity of funding and franchise, complexity and opacity of balance sheets, and moral hazard risks for bondholders from compensation incentives.
— Environmental challenges increase: weak global economic environment, elevated market uncertainty and volatility, increased regulatory capital requirements andrestrictions, higher funding costs and wider credit spreads.
If you want to get specific, click to enlarge the chart below and then compare the banks’ current ratings with Nomura’s guess for how they’ll emerge from the Moody’s review (the far-right column). We’ve also posted the note in the usual place:
Again, we’re not suggesting that investors should take a future downgrade seriously for what they’ll learn about the companies, nor are we about to stop being deliciously condescending to the CRAs.
But a downgrade might still matter for a few reasons. One is the possibility of higher long-term funding costs, though this is impossible to anticipate in advance and at this point lenders and bond investors are probably more discerning. Another worry is that a downgrade will increase the amount of collateral these institutions have to pledge to their funding counterparties. Finally there is straightforward headline risk, though this is surely the least important of the three.
Nomura reckons that collateral posting won’t be much of a problem, as banks have taken quite a few steps to lessen the threat of being brought down by sudden calls:
For example, they have reduced reliance on commercial paper, built up significant liquidity buffers, reduced repo on less-liquid assets with Rule 2a-7 money funds, termed out repo at the broker dealer subs, moved as much business as possible to their highly rated bank subs, prepared key counterparties (most will get that this is driven by a methodology change and not a change in the banks’ credit profile) and prefunded much of their funding needs over the next 12 months. While there will be some collateral calls driven by further downgrades, they are very manageable in the context of the banks’ liquidity pools. Even if Morgan Stanley were to be downgraded 3 notches by Moody’s (and also 1 notch by S&P), its additional collateral posting requirements would be a manageable $4.7bn in relation to the firm’s $182bn liquidity buffer.
The analysts also warn that despite the perceived irrelevance of the CRAs, shareholders have typically taken a hit on previous downgrades:
Though Moody’s ratings review has been well telegraphed and investors have typically dismissed the credit ratings impact to bank stock prices, we think headline risk for thestocks remains. If history is any guide, the universal bank and broker stocks could decline in the range of 2-5% when the Moody’s downgrades occur. We note that, on the day of S&P’s bank ratings downgrade (11/29/2011), the five large bank stocks we cover fell 2% on average while the S&P 500 closed up 0.2%. BAC fell 7.5%, while the S&P 500 closed down 2.9% on the day Moody’s downgraded BAC’s long-term rating to Baa1 on 9/21/2011, while Citi declined 5.2% as it was downgraded to A3-P-2.
Of course, the banks are all up big since then the S&P downgrade, so this last item is strictly more of a day-of-downgrade issue. Just something to put on the calendar for when it does happen.