5 Years After the Financial Crash, Moody's Gets It Right

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Everyone knew the downgrades were coming. Everyone knew the downgrades were going to be severe. Everyone knew the banks deserved them.

But when Moody's Investor Services actually announced the bank downgrades last Thursday, there was still some shock value to be had, even if the new ratings just confirmed what everyone already knew: Most of the country's biggest banks aren't rock-solid debtors and haven't been for some time.

Finding out who's naughty or nice
Back in February, Moody's Investor Services announced that it would conduct a sweeping review of more than 100 banks, the most systemically important of which operated globally and in the big capital markets. The review would be extensive, examining the failures of securities companies going back 40 years, including such notable blowups as Lehman Brothers, MF Global, and Bear Stearns.

Moody's had given prior guidance about the downgrades, presumably so the banks and relevant counterparties could begin preparing their businesses for what would almost certainly lie ahead:

  • Bank of America (NYSE: BAC  ) faced a possible one-notch downgrade.
  • Citigroup (NYSE: C  ) , Goldman Sachs, and JPMorgan Chase (NYSE: JPM  ) all faced possible two-notch downgrades.
  • Morgan Stanley (NYSE: MS  ) faced a possible three-notch downgrade.

Superbank darling Wells Fargo (NYSE: WFC  ) wasn't mentioned on Moody's hit list, but with Credit Suisse and UBS both facing a possible three-notch downgrade, Europe's big banks wouldn't be spared Moody's late-to-the-party eagle eye, either.

A few surprises, but mainly not
With one notable exception, most of the U.S. banks in Moody's crosshairs fared as expected:

  • Bank of America was downgraded one-notch, from Baa1 to Baa2.
  • Citi lost two notches, from A3 to Baa2.
  • Goldman Sachs lost its expected two notches, taking it from A1 to A3.
  • JPMorgan also lost its expected two grades, moving from Aa3 to A2.

The surprise winner in the bunch was Morgan Stanley, which was downgraded only two notches rather than the expected three, dropping it from A2 to Baa1. The perennial Wall Street investment bank had lobbied Moody's heavily over the past four months, begging for slack. Whatever the bank said, apparently it worked.

Europe's big banks came out pretty much as expected, too, with another notable exception. Credit Suisse was hacked down three notches, the only bank under review to take a three-notch hit. And finally, just so America's northern neighbors wouldn't feel left out, Moody's also downgraded Royal Bank of Canada.

We have nothing to fear but the repo market
When Moody's review was announced in February, the most extreme fear surrounding the potential downgrades was that some banks might be shut out of the "repo market." Short for "repurchase market," the repo market is the funding mechanism from which banks raise short-term loans, sometimes for as short a period as overnight.

Being shut out of the repo market was one of the proximate causes of the bankruptcy of Lehman Brothers, which at that time depended on the shadow-banking mechanism for its day-to-day solvency. No one's talking about that right now, but if the repo market freezes up again, the financial system will be in trouble once again. Reduced credit ratings could also mean borrowing costs will go up.

And then there's the potential cost of debt buyouts for clients who can no longer invest with a bank below a certain credit rating. Here's what the banks say the downgrades will cost each all in toll:

  • JPMorgan: $3.45 billion
  • B of A: $2.7 billion
  • Citi: $2.1 billion
  • Goldman: $2.2 billion

Morgan Stanley had initially estimated a $9.6 billion hit for a three-notch downgrade. It's probably safe to assume that the two-notch downgrade will cost less than that.

Better late than never?
So if everyone knew bad news was coming, and knew it in such great detail so far in advance, do the actual downgrades even matter?

The day after they were announced, banks stocks were up, with JPMorgan and Morgan Stanley each gaining 1%. An article in The Wall Street Journal suggested that investors were expressing relief that the bad news everyone knew was coming had finally been delivered; as such, now everyone could relax a bit and get on with life. A reasonable guess.

But regardless of that, most people had figured out five years ago that the world had changed, that the big banks weren't the rock-solid institutions they were made out to be. Since then, the superbanks have been in a near-constant state of adjustment.

The 2,300 pages of Dodd-Frank are chock-full of new regulation, including the Volcker Rule, which stops banks from making speculative bets. Higher capital-reserve requirements and decreased leverage ratios, courtesy of the Basel III banking accords as well as Dodd-Frank, have also made the banks much safer than they were. There are even a few in Congress who want to break up the country's six biggest banks, taking on the "too big to fail" issue about as directly as is possible.

These downgrades by Moody's, then, the same Moody's that stamped "AAA" on the creaky collateralized debt obligations that helped crash the financial system, are part of the banking system's ongoing, post-crisis adjustment. Moody's is just coming to the reality the rest of planet finance was already living in.

Banks will lose some money as the result of the downgrades, and profits will probably take a hit, an unhappy thought for shareholders -- unless, of course, the banks decide to pass the costs onto customers, an unhappy thought for them. However you look at it, someone's going to pay for the downgrades, but the costs will be absorbable, and none of the banks will go out of business because of them.

And always remember, even in this age of post-crisis bank wariness and weariness, the right kind of bank can still be a great investment. In that spirit, learn about some straightforward and profitable bank stocks any investor can get his or her head around, including one Warren Buffett would have loved in his earlier years, in this Motley Fool special free report: "The Stocks Only the Smartest Investors Are Buying." Take a minute and download your copy while it's still available

Fool contributor John Grgurich can be a bit moody sometimes himself, but he owns no shares of 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, Wells Fargo, Bank of America, and Citigroup and has created a covered strangle position in Wells Fargo. Motley Fool newsletter services have recommended buying shares of Wells Fargo and Moody's. The Motley Fool has a positively gripping 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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  • Report this Comment On July 19, 2012, at 4:20 PM, MHedgeFundTrader wrote:

    Buried in the recently passed Dodd-Frank financial reform bill are massive financial rewards for turning in your boss. The SEC is hoping that multimillion dollar rewards amounting to 10%-30% of sanction amounts will drive a stampede of whistleblowers to their doors with evidence of malfeasance and fraud by their employers.

    If such rules were in place at the time of the settlement with Goldman Sachs (GS), the bonus, in theory, could have been worth up to $500 million. Wall Street firms are bracing themselves for an onslaught of claims, legitimate and otherwise, by droves of hungry gold diggers looking for an early retirement.

    Don’t count on this as a get rich quick scheme. Government hurdles to meet the requirement of a true stoolie can be daunting. The standard of evidence demanded is high, and must be matched with the violation of specific federal laws. Idle chit chat at the water cooler won’t do. Litigation can stretch out over five years, involve substantial legal costs, and often lead to a non-financial settlement with no reward.

    Having “rat” on your resume doesn’t exactly look good either. Just ask Sherron Watkins, the in house CPA who turned in energy giant Enron’s Ken Lay, Andy Fastow, and Jeffrey Skilling just before it crashed in flames. Nearly a decade later, Sherron earns a modest living on the lecture circuit warning of the risks of false accounting, and whistleblowing.

    The Mad Hedge Fund Trader

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