Get Ready: Bank Stocks May Be About to Fall Even Further

It hasn't been a great spring for bank stocks already, and even after JPMorgan Chase's (NYSE: JPM  ) surprise $2 billion trading loss, things may be about to get worse. Moody's Investors Service is currently reviewing the status of 17 banks, with credit-rating downgrades for all a serious possibility. Here's what we know so far, and why bank investors might want to brace themselves.

Moody's most wanted
Moody's announced the review in February, targeting 17 banks that operate globally and in the big capital markets. Banks of note under review include Bank of America (NYSE: BAC  ) , which is facing a possible one-notch downgrade; Citigroup (NYSE: C  ) , Goldman Sachs (NYSE: GS  ) , and JPMorgan Chase, all facing possible two-notch downgrades; and Morgan Stanley (NYSE: MS  ) , facing a possible three-notch downgrade.

In the course of their review, Moody's analysts are looking at the failure rate of securities companies going back as far as 40 years. The list includes such infamous names as MF Global, Bear Stearns, and Lehman Brothers. Speaking to the Financial Times on the review, Moody's analyst Peter Nerby recently said: "The level of failures and near failures is not consistent with an investment-grade industry."

Final judgments won't be rendered until next month, but if this comment is any indication, the situation isn't looking good.

The grim repo market
Commenting on the impact of the possible downgrades, Sean Jones, another Moody's analyst assigned to the 17-bank review, told the Financial Times: "It's a potentially sizeable move on companies that issue a lot of debt." One of the primary fears of the banks is the issue of funding, and the repo market in particular.

As a refresher, the "repo market" -- short for "repurchase market" -- is a short-term funding mechanism in which banks from around the world raise overnight loans. The term made it into the public consciousness in the throes of the financial crisis. As banks were battening down their hatches for fear of not having enough capital on hand and the "credit crunch" began in earnest, banks that depended on the repo market to stay solvent on a day-to-day basis suddenly found themselves in trouble.

Banks deemed not creditworthy (say, because of a credit-rating downgrade) could theoretically find themselves shut out of the repo market -- one of the proximate causes of Lehman's downfall. In the case of this review by Moody's, the chance that any of these big banks would be completely unable to secure funding is unlikely. But at the very least, banks could face an increase in the costs associated with borrowing money -- cutting into profitability, competitiveness, and, therefore, the ability to attract investors.

The unexcited investor effect
And just like companies in any other industry, banks need investors -- excited investors, the kind who drive stock prices up and keep them there, which is precisely where they haven't been since the sector peaked in March. Since late in that month, in fact, the financials sector of the S&P 500 has dropped 6.4% from its 2012 high.

Specifically in that time period:

  • Share prices in Morgan Stanley have fallen 26.5%.
  • Share prices in Bank of America have fallen 22.5%.

In addition:

  • Shares of Goldman Sachs are down 17% from their year high.
  • Shares of JPMorgan Chase are down 12% from their year high.
  • Share prices in Citigroup are down 19.5% over the past six weeks alone.

Hang on to your hats, and your T-Bills
For bank investors, then, this ratings review -- and the seemingly certain downgrades to follow -- is the last thing they need. And for potential investors already wary of investing in banks, this will only make them more so.

But Moody's does have a point. Investment-grade products are supposed to be the next best thing to money. Treasury bills are a good example; when you buy a T-bill, you expect your money's going to be there when the bond matures. There's really no question in your mind. Nothing is 100% certain, not even that pile of gold buried in your basement, but you can reasonably expect certain securities or debt instruments to be close.

Given the recent history of the financial sector, it's fair to say that many of the companies that make it up are, frankly, not investment-grade. But maybe this review will be another good reason for the banks to continue cleaning up their balance sheets, getting back on the straight and narrow, and moving closer back to what they used to be -- utterly boring but completely reliable places to keep your money in and to invest in.

On the subject of great, traditional bank stocks, check out our special free report and learn about some delightfully straightforward bank stocks, including one Warren Buffett could have loved in his earlier years. The report is titled "The Stocks Only the Smartest Investors Are Buying," and you can download your copy while it's still available

Fool contributor John Grgurich is crossing his fingers that Moody's never decides to look at his checking account, and he owns no shares in any of the companies mentioned in this column. Follow John's dispatches from the bloody front lines of capitalism on Twitter, @TMFGrgurich. The Motley Fool owns shares of JPMorgan Chase, Citigroup, and Bank of America. Motley Fool newsletter services have recommended buying shares of Goldman Sachs and Moody's. The Motley Fool has a wildly entertaining disclosure policy. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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