Bank Ratings Cuts Are a Lasting Risk

NEW YORK ( TheStreet) -- Forgive bank investors for wondering whether a 2012 rally is more like "déjà vu all over again," after previous recoveries were lost to a next leg of the financial crisis.

On Monday, industry bellwether JPMorgan Chase ( JPM) finally recovered to positive territory for the last 12 months, benefitting from a near 40% 2012 stock surge as bank earnings and dividend payout expectations rise on the heels of Federal Reserve stress tests.

Now, investors should recount the remaining risks to banks before calling a rally a recovery.

Ratings downgrades remain an imminent threat after housing-crisis related lawsuits move toward resolution and the European debt spiral abates. With optimism turning some industry skeptics into bulls, preparing for a string of ratings cuts by Moody's helps to reveal the biggest lingering uncertainties in the banking system, even if they won't precipitate a new crisis.

For U.S. bank giants, the prospect of bond ratings downgrades looms as a threat, even after the industry exited severe stress tests with a relatively clean bill of health. " I nvestors should be aware that U.S. and European investment banks may face headline risk again from credit ratings downgrades by Moody's in the coming weeks," wrote Nomura analyst Glenn Schorr in a March 19 note assessing the impact of Moody's ratings review announced in February.

Schorr calculates that on a downgrade, large bank stocks could drop between 2% to 5%. "Though Moody's ratings review has been well telegraphed and investors have typically dismissed the credit ratings impact to bank stock prices, we think headline risk for the stocks remains."

In retrospect, a series of bank stock swoons on ratings cuts last fall represented a buying opportunity. If investors weren't to see a long-term impact of new downgrades, a possible ratings-based selloff could be short-lived.

JPMorgan shares are up over 38% in 2012, while peers like Goldman Sachs, Morgan Stanley and Citigroup post similar sized gains. The top financial performer on the Down Jones Industrial Average, Bank of America's near 80% gain has nearly quadrupled the KBW Bank Index's ( KBW) 20% gain.

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A worst-case scenario that cuts banks to low-investment grade ratings won't be the crisis-inducing threat it might have been in the past. In August 2007, a ratings cut to thousands of subprime mortgage securities held off of bank balance sheets started a credit crunch that put some banks on the brink and forced Central Banks into action.

But bank balance sheets, cleared by the Fed to withstand a 20% slump in housing and a 50% stock drop, are likely to handle larger ratings pressures. "What we've seen with the largest banks, and U.S. banks in particular, is that their liquidity profile has improved after the crisis," says Joo-Yung Lee, the head of Fitch Ratings' North American financial institutions team.

A set of possible multi-notch downgrades won't drive banks into a capital spiral, even if they cost a combined $20 billion for JPMorgan, Bank of America ( BAC), Morgan Stanley ( MS), Citigroup ( C ) and Goldman Sachs ( GS), as the banks have disclosed. Analysis compiled by Nomura shows that a worst case ratings-based cost would represent less than 2% of banks' available capital.

Instead, a set of Moody's downgrades would be more of a symptom of a new reality for banks and not a leading indicator.

"In blunt terms, in our view, Moody's just doesn't think it is as good an industry as they did in the past," notes Schorr, who says the industry average rating could fall to "Baa." Four years ago, few on Wall Street would have said banks couldn't survive such ratings. Now, with transformed balance sheets and new funding sources, known as liquidity, ratings cuts are a headwind for profitability but not a deathblow.

"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 February when announcing its ratings review.

"This should have been done a long time ago," says Morningstar financial institutions credit analyst Jim Leonard of the review. Instead of expecting ratings cuts to expose bank balance sheet holes, Leonard is more concerned by economic threats. "In Europe there are still a lot of problems that need to be solved, and that's what's really driving the banks."

With regulatory overhaul like the Dodd Frank Act and its ban on risky trading known as the Volcker Rule still pending, banks are lobbying to ensure that new rules don't cut at core earnings.

"We have to be very careful that we don't destroy that market making ," JPMorgan Chief Executive Jamie Dimon said in January. As regulators work to remove risk from the banking system, agencies may cut ratings if regulators ban key Wall Street activities like matching bond, currency and commodity buyers with seller.

If done right, proprietary trading bans could take risk out of the banking system with little impact to profits. "From June 2006 through December 2010, profits from proprietary trading were about $15.4 billion but offset by $15.6 billion in losses," says Mark Williams, a former Federal Reserve examiner, who questions the timing of new prospective cuts.

Ratings agencies may be preparing for imperfect execution. "Reducing proprietary trading does take some of the risk out of banks. On the other hand, some of the rules are not yet clear... It's a possibility that new regulations start looking at market making, limiting day-to-day bank operations," says Stuart Plesser, a director of financial institutions ratings at Standard & Poor's.

Meanwhile, cuts to government debt ratings in Europe and the U.S. could impact banks, as they did in the second half of 2011. "If the U.S. government was downgraded, bank ratings would go down as well," notes Plesser. In August, Standard & Poor's cut the U.S. government's rating to AA+ and marked that rating as "negative."

Currently, Standard & Poor's has a "negative" rating on all of the five largest U.S. banks except for JPMorgan, while Fitch Ratings holds their ratings at "stable." If all cuts under review by Moody's were made and matched Standard & Poor's and Fitch, they currently hold higher ratings and a more positive outlook on average JPMorgan's "fortress balance" sheet would be an industry leader at A2, a not so prestigious rating.

While sector-wide ratings cuts aren't seen as a crucible for banks, investors should watch for a scenario where just a few banks are downgraded, notes Schorr of Nomura. In that case, some banks might see a withdrawal of counterparties, or a "second-order effect," notes Lee of Fitch Ratings.

In March, stress test results and capital return programs gave analysts cause to boost the earnings estimates for the largest U.S. investment banks. Overall, analysts polled by Bloomberg give JPMorgan shares a price target of $49.04, with 34 "buy" ratings to go with 5 "holds." Goldman Sachs and Morgan Stanley shares warrant price targets of $134.05 and $22.14, respectively.

For more on bank investments, see why Warren Buffett is resting as John Paulson digs in and what the investment guru knows about bank investing that you don't. See why JPMorgan is set to reign over Wall Street for more on first quarter investment banking earnings.

-- Written by Antoine Gara in New York.

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