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Bank Stock Rally's Biggest Enemy (Update 1)

"Capital markets firms are confronting evolving challenges, such as more fragile funding conditions, wider credit spreads, increased regulatory burdens and more difficult operating conditions," said Moody's in a report of its ratings review.

"These difficulties, together with inherent vulnerabilities such as confidence-sensitivity, interconnectedness, and opacity of risk, have diminished the longer term profitability and growth prospects of these firms," added the agency in its analysis.

Currently, Moody's holds Bank of America in the lowest regard with a Baa1 issuer rating that is two notches above its speculative grade, commonly known as junk. If Moody's followed through with its cut review, Citigroup and Morgan Stanley would join Bank of America at Baa2, a notch above junk. Goldman Sachs would fall to A3 and JPMorgan would fall to A2, the level that the ratings firm holds for Wells Fargo (WFC - Get Report), which it didn't subject to review.

Stock investors probably didn't fret much over Moody's ratings review, as bank stocks continued a 2012 rally that's boosted Bank of America shares by nearly 50% and those of Morgan Stanley, Citigroup and Goldman Sachs by roughly 25%. Neither did traders of bank credit default swaps, which rise in price when institutions appear more risky and fall when concerns ease. CDS prices fell for all of the U.S. banks under review by Moody's.

But the potential for Moody's to follow through with downgrades and for peer agencies to also enact cuts should give investors pause for concern. Starting in September, Moody's initiated a sweeping cut to the banking sector, which was followed by Standard & Poor's in September and Fitch in December. The rating moves left bank shares battered and many firms on track to post over 20% 2011 stock drops.

Currently, Standard & Poor's has a 'negative' rating on all of the five largest U.S. banks except for JPMorgan, while Fitch Ratings holds all of their ratings at "stable." It signals that like in 2011, Standard & Poor's is likely to act after Moody's but before Fitch in any potential ratings re-assessment.

A Monday report by CreditSights noted that Moody's will likely reduce "standalone" ratings for the group as a whole "from the single-A range to the Baa range probably beginning in the first quarter of 2012 with a review notification and ratings actions within 90 days or so thereafter," according to the report. Standalone ratings refer to ratings that assume no government support for the banks in question.

A recent Fitch Ratings report showed that over nineteen percent of bank bonds were downgraded in 2011, with financial institution cuts accelerating in the fourth quarter. It means that 2011 was the first year of ratings declines since 2007, putting just 15% of banks at an AAA or AA rating, according to Fitch Ratings. Prior to the credit crunch, over 50% of banks warranted those exemplary ratings.

"U.S. bond market's rating drift turned more negative in the last quarter of 2011," note Fitch Ratings analysts Eric Rosenthal and Mariarosa Verda in a Feb. 1 report. "The vast majority of downgrades in the latter part of 2011 were associated with banks, reigniting a four-year decline in the banking sector's rating profile," add the Fitch Ratings analysts.

"Over time market conditions are likely to ease, but Fitch expects market volatility to remain above historical averages and economic growth in developed markets to remain subdued for a prolonged period. This makes many business lines in securities operations more difficult, due to lower activity and higher funding costs," said Fitch Ratings in December.

As banks near analyst price targets, a simple valuation rise signals that 2012 gains may be muted after a fast start to the year. Analyst estimates compiled by Bloomberg give Bank of America a price target of $9.04, while competitors Citigroup and JPMorgan have price targets of $40.38 and $45.89 a share, respectively. Investment banks Goldman Sachs and Morgan Stanley have price targets of $128.18 a share and $21.86 a share, respectively according to analyst estimates, which signal that Citigroup and JPMorgan may gain the most from current valuations.

For more on bank stocks, see the financial stocks bought and sold by hedge funds and 7 bank stocks loved by Deutsche Bank.

-- Written by Antoine Gara in New York

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