Bank Stock Rally's Biggest Enemy (Update 1)

Updated to with additional information throughout..

NEW YORK ( TheStreet) -- Bank of America ( BAC), Citigroup ( C), Morgan Stanley ( MS), Goldman Sachs ( GS) and JPMorgan ( JPM) have a debt downgrade problem that could put a quick end to their 2012 stock rally.

After a big 2012 share surge for many big financial names, Thursday's announcement by ratings agency Moody's that it is reviewing big bank debt will be a harsh reminder to bank stock investors of the pessimism that swept over the sector last year following a string of sovereign and bank debt downgrades.

Credit ratings -- a key determinant for bank borrowing costs -- could cut into profit margins and recently revitalized bank balance sheets. If the ratings of banks continue a 2011 slide as agencies like Moody's, Standard & Poor's and Fitch Ratings reassess their earnings prospects and risk, the moves could begin costing serious money.

On Thursday, Moody's said that it is reviewing ratings cuts that could lead to a three notch drop for Morgan Stanley, a two notch drop for JPMorgan, Citigroup and Goldman Sachs and a one notch cut to Bank of America. While the prospective cuts would still keep the ratings of those banks at the investment grade level, if the moves were made by Moody's and matched by peer ratings agencies, Bloomberg reports that the cuts could cost those firms a combined $19 billion, according to compilations of disclosures on third quarter earnings.

That's because as bank ratings slide, bank trading counterparties may demand more collateral to compensate for an increasing credit risk.

Such increased capital costs would come at an inopportune time for investment banks and lenders with a significant exposure to the capital markets, which are in the midst of a big drop in trading and deal activity in 2012 to follow a weak second half of 2011. Ratings downgrades that make many of those businesses more expensive to run would be a double indemnity, as earnings suffer from a slow market.

For more on banks, see why struggling bank bull John Paulson dumped his holdings in America's largest banks.

On Thursday, the Wall Street Journal reported that in filings to the Federal Reserve, Bank of America indicated that it would sell its U.S. Trust wealth management unit if a severe downturn forced it to raise capital, though executives feel such a plan won't be needed and no negotiations are underway.

Separately, Goldman Sachs's buyout unit and private equity firm Advent International unveiled an acquisition of credit information service TransUnion for $3 billion. The business was previously owned by Chicago-based private equity firm Madison Dearborn Partners and the Pritzker family.

"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), 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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