Why You Shouldn't Care That Moody's Downgraded These 4 Banks

This past Thursday ratings agency Moody's (NYSE: MCO  ) downgraded the credit rating for four major U.S. banks: Morgan Stanley (NYSE: MS  ) , JPMorgan Chase (NYSE: JPM  ) , Goldman Sachs (NYSE: GS  ) , and the Bank of New York Mellon (NYSE: BK  )  after a review of both industry wide trends and considerations for each institution specifically.

If you're an investor in any of these institutions, you shouldn't care. Here's why.

Terrible track record
First of all, everything we learn from Moody's or any other ratings agency should always be taken with a sizable grain of salt. If the financial crisis taught us anything, its to do your own homework. And certainly don't put all your faith into the opinion of a ratings agency. 

That being said, Moody's is a reputable company with sophisticated models developed by very smart people. Sophisticated models that, well, haven't really worked all that well in recent years.

  April 2007 November 2013 Change
Morgan Stanley Aa3 Baa2 Down 5 ratings
JPMorgan Chase Aa2 A3 Down 4 ratings
Goldman Sachs Aa3 Baa1 Down 4 ratings
Bank of NY Mellon Aaa Aa2 Down 2 ratings

Source: Moodys.com.

Based on this chart, we must assume these banks are today either considerably more risky than they were just before the financial crisis erupted in the spring of 2007, or that Moody's was so unequivocally bad in their ratings back in 2007 that the disparity is due to an improvement in their systems. Both options are a bit of a hard sell, if you ask me.

As a market participant, I am placing no confidence whatsoever in Moody's assessment of these banks. It simply does not have the track record to deserve the credit. 

Cost of funds
Moody's report indicates that today there is less of an implied guarantee from the U.S. government to support these institutions in the event of another crisis. Without this implied backing, Moody's claims that the cost of capital will increase, tightening margins and weakening the earnings ability for each institution.

Data from the FDIC's Q2 2013 Quarterly Banking Profile, charted below, does indicate that large institutions have enjoyed a lower cost of funding since the financial crisis. It also makes logical sense that some of that cost advantage could come from investor confidence based on an implied government backing.

Source: FDIC.

That being said, the gap between large institutions and small institutions has narrowed in recent quarters, driven not by an increase in costs for large institutions but by a decrease in costs at smaller institutions.

Institutions by Size 6/30/13 6/30/2012 % Change
> $10 billion 0.40% 0.51% (21.6)%
$1 to $10 billion 0.53% 0.71% (25.4)%
$100 million to $1 billion 0.59% 0.79% (25.3)%
< $100 million 0.56% 0.73% (23.2)%

Source: FDIC.

The chart and the data bear it out. Cost of funds are declining across the industry, but the decline is more rapid at smaller institutions than large ones. 

Bottom line: The megabanks today really don't enjoy much of an advantage in terms of costs of funds, at least not clearly attributed to an implied government backing.

An alternative theory
In my view, it's more likely that the cost advantage stems from having a disproportionate market share of low-cost demand deposits. Checking accounts, savings accounts, and even certificates of deposit are all paying laughably low interest rates in today's world. It follows the banks with the highest concentrations of these funds will have a lower cost of capital.

Fellow Fool John Maxfield highlights the nation's top 10 deposit holders here, and it should come as little surprise that both JPMorgan Chase and the Bank of New York Mellon on are the list.

A final point -- what Moody's is and what it is not
If you are an investor in one or all of these banks and are concerned about your equity position because of the downgrade, I encourage you not to worry based on this fact alone. In fact, Moody's is not actually assessing the equity portion of the balance sheet. 

In the event of a catastrophic event where one or all of these banks were to fall into bankruptcy, Moody's ratings pay no mind to the shareholder. The concern is only of the likelihood of repayment to the company's debtors.

That being said, there's nothing wrong with monitoring your investments for ratings changes; a ratings change could be a harbinger for a change in the industry or at the company. Moody's analysis could point you to a new fact you may not have considered.

And that is the crux of it. An investment should be made after reviewing the data -- company data, industry data, and economic data -- and making your own decision. It's your hard earned money. Don't buy or sell because someone or some company recommends it. The best investors do their own homework, have their own point of view, and most fundamentally, make their own decisions.

A Moody's downgrade (or upgrade) is simply another data point in your analysis. And in my view, its a data point of very little value.

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