By Matthias Rieker
Moody's Investors Service is expected to announce next week downgrades of global banks' bond ratings, based largely on the banks' diminished profitability as they continue to struggle in a post-financial meltdown world.
The Moody's review of 17 global banks with capital-markets businesses is weighing on stock prices and angering bankers, who insist investment banking--which is a part of capital-markets operations--remains a valuable business. They downplay the impact of any rating change, which could cost them billions of dollars in additional collateral for derivative trades.
Citigroup Inc. (C) Chief Financial Officer John Gerspach told bank clients last month the approach Moody's takes toward bond ratings "is backward looking and does not provide adequate credit to the strength and diversity" of Citi's business or its main banking subsidiary, Citibank, according to a presentation posted on Citi's website.
Rather than simply looking at the credit ratings of Moody's and the other two major rating firms--Standard & Poor's and Fitch Inc.--investors take an "increasingly complex landscape" into consideration when they price debt. In addition to bond ratings, investors look at capital ratios, loan-loss reserves, spreads of bonds and credit default swaps, earnings and business strategy, and macroeconomic factors and geography, according to the presentation.
One important market metric--the price of insuring bank debt--suggests investors indeed are looking beyond bond ratings when they gauge risk levels.
Moody's said in February it would review the ratings of 17 banks with global capital-markets operations. Citi, J.P. Morgan Chase & Co. (JPM), Bank of America Corp. (BAC), Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) are the U.S. banks on the list.
Capital markets, which are a substantial part of these banks' operations, are less profitable than before the financial crisis, Moody's has said. That is because funding those businesses is more challenging, new regulations are imposing greater oversight and operational restrictions, and revenue is more volatile.
Different banks are facing different potential outcomes from the Moody's review. Bank of America might be downgraded one notch; Citi, Goldman, and J.P. Morgan two; and Morgan Stanley three, Moody's said. Under that scenario, Citi, Morgan Stanley and Bank of America would end up with the same rating, Baa2.
The financial market's yardstick for debt riskiness--credit default swaps--currently shows a divergence among the big U.S. banks under review, suggesting investors differentiate beyond bond ratings.
On Friday, it cost $411,000 to insure $10 million of Morgan Stanley's debt; $291,000 to insure the same amount of Bank of America debt and $265,000 to insure that amount at Citi. Morgan Stanley's CDS spreads worsened significantly since Moody's announced the review; Citi's worsened somewhat and Bank of America's remained virtually unchanged.
The CDS spreads reflect that the downgrade would have more impact on Morgan Stanley than on Citi, said RBC Capital Markets analyst Gerard Cassidy. Morgan Stanley CFO Ruth Porat told investors in April that the impact of a Moody's downgrade would be "managable." A potential three-notch downgrade would require the bank to restructure "only" 8% of its derivative contracts, she said.
Meanwhile, Royal Bank of Scotland PLC (RBS.LN, RBS), majority owned by the U.K. government, faces a potential one-notch downgrade, to A1, a higher debt rating than Citi would end up with. But it cost $331,000 to insure $10 million of RBS debt. And the debt of Banco Santander SA (STD, SAN.MC) of Madrid, which was downgraded last month to a A3, an even higher rating, is even more expensive to insure, even though it has no big capital markets operations.
A spokesman for Moody's declined to comment on the CDS spreads, and said the rating firm expects "to conclude the bank reviews by the end of June."
Stock prices of the five U.S. banks under review have fallen since the review was announced, and the Moody's review was one reason for the decline, trades and analysts said. Though Mr. Cassidy said the state of the U.S. economy, the European economy, and the direction of interest rates are more important factors for stock investors.
Citi's shares fell 13.4% since Feb. 15, to $27.53 on Friday, and Morgan Stanley is down 28%, to $13.64.
"It'd be surprised if there is a big reaction" when Moody's announces the actual downgrades. The one surprise could be a harsher than expected two-notch downgrade of J.P. Morgan Chase because of the bank's recent trading loss tied to its hedging strategy. "We think it is unlikely to happen," said Mr. Cassidy, of RBC Capital Markets, "but it cannot be ruled out completely."
Write to Matthias Rieker at firstname.lastname@example.org