Debt Downgrades: The Silent 2012 Bank Stock Killer
NEW YORK (
) - Bank stocks have been rallying in 2012 with the
Financial Select Sector SBDP
(XLF) - Get Report
rising nearly 14% and many of America's largest banks like
Bank of America
(BAC) - Get Report
,
Citigroup
(C) - Get Report
and
Morgan Stanley
(MS) - Get Report
posting roughly double those gains.
Less seen is a potentially lethal dynamic of recent bank ratings downgrades.
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.
Fitch Ratings also notes that financial institutions now represent only 27.1% of the overall corporate bond market, or $1.3 trillion worth of bonds, down from an over 50% 2007 share, when most banks had sterling credit ratings. As ratings fell, so did debt issuance, causing many financial institutions to sell assets and cut risky operations to rebuild capital. That's all come at a cost.
In December, Fitch Ratings downgraded the likes of Goldman Sachs, Citigroup and Bank of America and a host of other large banks around the world, noting that lenders "are particularly sensitive to the increased challenges the financial markets face."
Those downgrades followed similar November ratings cuts by
Standard & Poor's
and September cuts by
Moody's
. All of those ratings cuts cited a negative turn in economic conditions, slowing business volumes and increased government debt concerns. It means that for bank credit quality, there is a negative feedback look in place where a worsening of economic and government debt conditions pulls investors out of financial markets, adding to bank woes.That feedback look has big implications for U.S. banks.
In a November regulatory filing, Bank of America said that further downgrades from ratings, "could likely have a material adverse effect on our liquidity" and cut off its access to credit markets.
For large banks with trading and lending operations, fourth quarter earnings showed a steep drop in revenue from trading, stock and bond underwriting and advisory businesses, cutting into earnings even as credit losses stabilized and lending increased for many. If those capital markets problems were to persist it could precipitate further bank rating cuts, which would hit their profitability and even survival.
"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 bank stocks rally in 2012, watch for a continuation of the rating downgrade trend to put a damper on a strong start to the year for the financial sector.
For more on bank stocks, see the
10 best performing S&P 500 stocks in 2012
.
-- Written by Antoine Gara in New York
