Banks Biggest Stress Test Remains

NEW YORK ( TheStreet) -- JPMorgan Chase ( JPM) led the way in passing the Federal Reserve's stress tests and boosting payouts, but banks still face big risks that went untested.

For bank giants, the prospect of bond ratings downgrades or a worsening of the European debt crisis is a still-imminent threat, even after stress tests results added to a 2012 bank stock rally.

JPMorgan, Bank of America ( BAC), Citigroup ( C), Morgan Stanley ( MS) and Goldman Sachs ( GS) all face a debt downgrade at Moody's, in addition to an ebbing European crisis, which could yet stall a rally.

Stress test results showed stronger-than-expected dividend and share repurchase programs at some banks while others, like Citigroup, failed to meet the Fed's tests, sending capital return plans up in smoke.

But post-stress-test optimism may be dimmed by another highly anticipated event for banks: The conclusion of a Moody's ratings review may lead to multi-notch ratings cuts at giant lenders. A string of cuts could be a rally killer after a near-20% surge in the KBW Bank Index ( BKX) and an 8% Dow Jones Industrial Average rally in 2012. On Tuesday, an over-200-point rise fueled by stress test results put shares at multiyear highs.

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In February, Moody's said 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.

If agencies like Moody's, Standard & Poor's and Fitch Ratings continue to reposition bank ratings, the moves could cost serious money, which wasn't something the Federal Reserve accounted for in its stress tests released on Tuesday.

The Fed tests asked banks to have a tier 1 common capital ratio of above 5% when accounting for capital return plans and a near-apocalyptic set of market conditions in the U.S. Bank balance sheets were tested against a 21% drop in already battered housing prices, a 50% drop in still-recovering stock markets and a surge in the unemployment rate to 13%, a level not seen since the Great Depression. That scenario would cost the 19 banks tested a total of $534 billion. Within that figure, the Fed assumed $116 billion in trading and counterparty credit losses at six large U.S. banks tied to global markets.

A European slowdown, while not quantified, is assumed by the Fed to impact the six banks it highlighted as tied to global markets, contributing to a portion of overall trading losses. The Fed assumes a European slowdown could trigger a fall in the value of private equity and derivative assets, while widening credit default swap spreads on banks and sovereigns.

The tests didn't directly quantify a potential ratings-downgrade-based capital flight or the impact of a European credit crunch. Both of those scenarios drove a second-half bank swoon that may seem like a distant memory for many investors. When tests were first announced, KBW analyst Fred Cannon said that the methodology of the Fed distorts the import of the European crisis.

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, the cuts could cost a total of roughly $20 billion according to quarterly filings.

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, as in 2011, Standard & Poor's is likely to act after Moody's but before Fitch in any potential ratings re-assessment.

In a March 8 report, S&P noted that only sovereign debt ratings outweighed banks as having a negative bias. Presently the ratings agency holds a 25% negative bias on its bank ratings, posing a "greater than average" downgrade risk.

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.

"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.

As stress tests were being revealed by the Fed on Tuesday, JPMorgan announced that it would boost its quarterly dividend by 20% to 31 cents, while also launching a $15 billion buyback program. Wells Fargo nearly doubled its quarterly dividend to 22 cents and Morgan Stanley said its capital-return plans and a possible stake in Morgan Stanley Smith Barney were approved by the Fed. The Fed approved a Goldman Sachs dividend and buyback program. Bank of America didn't outline a capital return plan, but it also passed tests.

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-- Written by Antoine Gara in New York.

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