Bank Stocks Face Post-Stress Test Trauma

NEW YORK ( TheStreet) - It's not just the potential for bad stress-test news that can throw bank stocks into a tailspin and put a damper on a 2012 sector rally.

Bank of America ( BAC), Citigroup ( C), Morgan Stanley ( MS), Goldman Sachs ( GS) and JPMorgan Chase ( JPM) all face a debt downgrade that would throw shares deeper into negative territory.

For the Financial Select Sector SPDR ETF ( XLF), which has rallied over 11% in 2012 and the Dow Jones Industrial Average, which is up nearly 5% year-to-date, ratings downgrades could be a rally-killer. On Tuesday, an over 200 point slide represented the worst trading day of the year.

In February, Moody's said that it is reviewing big bank debt, with the potential for a harsh ratings assessment to remind investors of the pessimism that swept over the sector last fall.

For banks, a new string of debt ratings cuts be costly after the previous round provided more of a dent to confidence. If agencies like Moody's, Standard & Poor's and Fitch Ratings continue to reposition bank ratings, the moves could cost serious money.

Moody's said 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 and matched by peer agencies, Bloomberg reports that the cuts could cost those firms a combined $19 billion, according to compilations of disclosures on third quarter earnings.

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.

As bank ratings slide, trading counterparties may demand more collateral to compensate for an increasing credit risk. Increased capital costs would come at an inopportune time for banks 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.

"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 its ratings review.

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 40% and those of Citigroup and Goldman Sachs by roughly 25%. But the tide may yet turn.

As banks near analyst price targets, a valuation rise signals that 2012 gains may be muted after a fast 2012 start. Analyst estimates compiled by Bloomberg give Bank of America a price target of $9.13, while competitors Citigroup and JPMorgan have price targets of $40.72 and $47.50 a share, respectively. Investment banks Goldman Sachs and Morgan Stanley have price targets of $129.5 a share and $22.05 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.