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.

Content on this page requires a newer version of Adobe Flash Player.

Get Adobe Flash player

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."

If you liked this article you might like

These Powerful Corporate Executives Could Make a Run at the Presidency in 2020

JPMorgan CEO Jamie Dimon Attacks Bitcoin Again

SEC's Cyber-Gaffe Highlights Risk of Trump Budget Cuts at Agency

Bitcoin Will Soar to $5,000 Barring a Major Catastrophe

Strange Days at Apple