Moody's Downgrades Further Delay Banking Recovery
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Since sometime around 2005, I have had a pessimistic attitude toward the nation's largest banks. While I can see how Morgan Stanley (NYSE: MS), Citigroup (NYSE: C), and Bank of America (NYSE: BAC) can recover from the banking depression that began in 2007, I have long believed that a recovery to pre-2007 profitability was a long way away. Well, it got a little further away on June 21st when Moody's downgraded, in some cases substantially, many of the largest banks in the world.
Moody's did not drop all 15 banks' ratings indiscriminately. Moody's has been dropping bank ratings for months, and many in Europe and Asia have already been hit. Among the 15 banks at issue, Moody's made up three groups. JPMorgan Chase (NYSE: JPM), Royal Bank of Canada (RY), HSBC Holdings (HBC) and Credit Suisse (CS), while all downgraded, are still thought of by Moody's as strong institutions. The second tier, which included banks such as Goldman Sachs (GS), Barclays (BCS), and Deutsche Bank (DB), have less financial cushion against trading losses, and/or are more exposed to Europe. The third tier, which included banks such as Citigroup, Bank of America, and Morgan Stanley, will be in for substantial problems if Europe suddenly deteriorates further, or another big systemic shock comes along.
Something else I have believed for over twenty years is that it was a mistake to repeal the 1930's era Glass Steagall legislation that separated banks from investment houses. I realize that the legislation had been substantially whittled away by the time Congress officially repealed it in November, 1999. President Obama, before he became president, campaigned on the reversal of the repeal of Glass Steagall, but has since retreated from that position. Probably, having Lawrence Summers, the main architect of the repeal bill, within the administration had something to do with that. All fifteen of the downgrades made today, including the American banks I will discuss below, were downgraded at least in part due to the volatility of their investment banking activities.
The biggest loser in the downgrading party was Switzerland's second largest bank, Credit Suisse. The bank's debt was lowered three notches, the most Moody's rules allow for one change in rating, from Aa1 to A1. But Moody's raised the bank's outlook from negative to stable, and even with the current debt rating Credit Suisse has one of the highest ratings of any global bank that has a significant capital markets presence. It is commonly stated within the derivative trading community that parties wish to deal only with companies bearing at least an A1 credit rating on the other side of the transaction. Credit Suisse will therefore still be a preferred trading partner in the derivatives market, for better or worse.
Coming a little closer to home, the three largest domestic banks all received credit downgrades. JPMorgan was downgraded two notches, as its long term debt is now at Aa3. Moody's, in giving JPMorgan what is still a strong rating, noted that in addition to its volatile investment bank, it has many other more stable and consistent businesses, such as its retail bank. However, it still left the bank's long term debt with a negative outlook.
Citigroup's long term debt was also reduced two notches, to Baa2. Their short term paper rating dropped to P-2 from P-1. The new long term debt rating is just three notches above “junk” status, and Moody's maintained the negative outlook. Citigroup's rating is several notches below JPMorgan's because it does not have the proven earnings power to offset investing risk that JPMorgan has. Recall that Citigroup is focusing on markets in emerging countries, and pretty much giving up on growing its historically core North American business. Moody's has not seen evidence yet that the strategy will yield results. Citigroup's new rating is going to cost it plenty if it chooses to continue its derivatives business, as its low debt rating will require it to put up collateral with most other traders.
Morgan Stanley for instance, posted in a securities filing on May 7th that a credit downgrade, combined with its already less than stellar credit rating, could cost it as much as $7 billion in new collateral for trades. Morgan Stanley is at its core an investment bank, with minimal traditional banking activities. Already reeling from its role as lead underwriter in the fiasco known as the Facebook (FB) IPO, Moody's downgraded Morgan Stanley long term debt by two notches to Baa1, and its short term paper was downgraded to P2. While banks with large branch systems have been able to support their needs with an influx of inexpensive consumer deposits, Morgan Stanley does not have that option, and is more dependent on credit markets. On the other hand, today's price of about $14 per share is less than half of the current book value. This is a play for those willing to accept above average risk.
Bank of America's long term debt was also downgraded to Baa3. It is a shame what has become of this one time highly efficient, highly profitable regional bank. In seeking to become a national and international bank, it has taken what in retrospect were absurd risks, such as its 2008 purchase of Countrywide. Part of the rationale behind Moody's downgrades of Citigroup and Bank of America is that they are in the midst of restructurings that have not proven profitable as yet. Will Bank of America ever again approach realized earnings of the 1.3% to 1.4% of assets it routinely posted a decade ago? I cannot see that day. And that uncertainty went into Moody's analysis as well.
The integration of banking, capital markets, and insurance has been a disaster for the industry, the economy, and the nation at large. Large banks have gotten so large, that their direction often leads the broader economy, instead of merely reflecting it. Again, for here and now, banks are so awash with consumer deposits that the ratings changes will have little impact. Yet, over the long haul, if confidence is lost in these banks, the lack of access to inexpensive capital could be devastating. Investment banks have no business being entwined in commercial banking companies. The sooner something is done about this, the better.
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