Ratings downgrades: Adding insult to injury
The rationale for Moody’s multiple downgrades of global banks was scathing but now, seemingly axiomatic.
Blink, and you might even have missed it: Moody’s long-promised downgrades of 15 global banks on June 21 failed to ignite market panic – despite expectations to the contrary – over the funding capacity of these institutions in an already stressed market.
In the US, affected financial stocks traded up on the news, as Moody’s wave of downgrades was less deadly than feared. Morgan Stanley, for example, was downgraded by two notches to Baa1. This outcome for Morgan Stanley was better than the expected three-notch downgrade, which Morgan Stanley’s CEO James Gorman fought furiously to avoid, claiming the ratings agency underscored the bank’s strong relationship with Mitsubishi UFJ.
On average, the leading US banks were downgraded two notches from a holding company median rating of A2 to Baa1 while European banks were similarly downgraded by one to two notches.
Market players said Moody’s rating shifts were, in general, well-anticipated, and already priced into stock and bond prices. In short, market consensus decreed that the moves would not materially worsen the drought in banks’ long-term funding markets. Even though financial markets are now well accustomed to a daily onslaught of bad news, the relatively sanguine market reaction to Moody’s downgrades would have been hard to imagine this time last year.
That’s probably because Moody’s rationale for the move was scathing but now, seemingly axiomatic: global capital market-oriented banks are structurally less creditworthy if they rely on sovereign support, wholesale funding markets and/or leverage to extract returns from capital-intensive businesses. Quelle surprise.
And Moody’s move is unlikely to trigger a jump in near-term funding terms for banks. US banks, in particular, have had big dramatic shifts to their near-term capital, funding and liquidity ratios in recent years, and fewer European banks, in general, are dependent on ratings-sensitive short-term funding markets while they drink from the European Central Bank liquidity tap.
What’s more, according to Credit Suisse, the collateral costs are manageable – for US banks, excluding Morgan Stanley, the collateral outflows from a two-notch downgrade are approximately 1% to 2% of available liquidity – while higher unsecured lending costs are already structurally hard-wired into banks’ business models.
Moody’s ratings shift could yet have a profound and long-lasting impact on the sector by further undermining the profitability prospects of global investment banks, widening the gulf between the top-tier investment banks and the rest while accelerating the shift among the US dealer community to adopt central clearing for OTC derivatives.
The question arises: are such financials a viable investable asset class, given weak profitability prospects in ratings-sensitive fields in prime brokerage and derivatives? What’s more, the downgrades could lead to a loss of derivatives business for weaker players, further exposing the gulf in the profitability/creditworthiness of the top-tier US investment banks, such as Goldman Sachs and JPMorgan, and the likes of Morgan Stanley.
Meanwhile, as Credit Suisse notes, the buy side and dealers in the OTC derivatives market are likely to speed up their adoption of central clearing in order to reduce exposures to lower-rated counterparty risk while seeking to avoid concentrating exposures to the higher-rated counterparties. In other words, dismiss Moody’s downgrades at your peril.