NEW YORK ( TheStreet) -- Moody's Investor Service slashed the ratings of 15 of the worlds largest banks late on Thursday as part of a long-threatened review of their creditworthiness. Moody's cut Morgan Stanley ( MS) by two notches to Baa1, instead of a possible three notch cut. The agency also cut JPMorgan Chase ( JPM), Citigroup ( C) and Goldman Sachs ( GS) by two notches and Bank of America ( BAC) by a notch in a sweeping ratings change that still gives the nation's largest banks a negative outlook.
The cuts were not the worst case scenario after Moody's announced in February that it was considering downgrades to the worlds largest banks to better reflect the impact of new regulations and the risks of dealing in capital markets amid a worsening debt crisis in Europe and the United States. While the downgrades could cost banks billions if matched by ratings agencies Standard & Poor's and Fitch, they may not be a panacea, even after bank stocks and the wider markets tumbled in Thursday trading after reports surfaced that cuts could come as early as the market close. The downgrades by Moody's could raise bank borrowing costs as lenders ask for more collateral on borrowings and some investors in short term debt markets diversify from riskier institutions. In a first quarter analyst call, Blackrock ( BLK) chief executive Larry Fink said that the world's largest money manager would consider diversifying from some trading partners if they were downgraded. "All of the banks affected by today's actions have significant exposure to the volatility and risk of outsized losses inherent to capital markets activities," said Moody's Global Banking Managing Director Greg Bauer, in a statement. Moody's also downgraded European banking giants UBS ( UBS), Credit Suisse ( CS), Barclays ( BCS), BNP Paribas, HSBC ( HBC) and Deutsche Bank ( DB) in its global bank ratings reassessment. Notably, it cut Credit Suisse's ratings by three notches. In Thursday trading, markets tumbled on reports that the downgrade would come after the market close, leading the Dow Jones Industrial Average lower by over 250 points, or nearly 2%, in one of the worst trading drops of 2012. The financial sector underperformed the broader market, with the Financial Sector Select ETF ( XLF) dropping over 2%, highlighted by an over 3% drop in Citigroup's shares. In February, Moody's put the largest banks in the U.S. and Europe under review for between one and three notch downgrades, citing risky capital markets activities, new regulations that cut at earnings prospects and a worsening of government debt holdings. The cuts put Morgan Stanley and Citigroup at a higher level than Bank of America's Baa2 rating, which at two notches above a speculative grade or 'junk' rating, is the lowest rated of the nation's largest banks. Goldman Sachs fell to A3 and JPMorgan fell to A2, the level that the ratings firm holds for Wells Fargo ( WFC), which it didn't subject to review in February. Analysts were mixed on what the downgrades could entail for banking giants. "We think there will be short-term pressure on MS spreads upon Moody's release, but that will be followed by a steady rally in spreads," wrote Sterne Agee analyst Donald Jones, in a Thursday note to clients. CLSA analyst Mike Mayo said that the downgrades have already been priced into bank stocks in a Wednesday note to clients; however, a three notch cut of Morgan Stanley's credit ratings could have been a surprise investors. "The big surprise would be if there is more than a one-notch downgrade for big banks, other than Morgan Stanley, or if another rating agency follows suit sooner than expected," wrote Mayo. In a statement Morgan Stanley said, "while Moody's revised ratings are better than its initial guidance of up to three notches, we believe the ratings still do not fully reflect the key strategic actions we have taken in recent years." In after-hours Thursday trading, Morgan Stanley surged over 3% to $14.43 on its two-notch cut. Others had harsher words for Moody's. "Citi strongly disagrees with Moody's analysis of the banking industry and firmly believes its downgrade of Citi is arbitrary and completely unwarranted," said the bank in a statement, citing its improved risk management, capital and liquidity. In an April note to clients, Bernstein Research analyst Brad Hintz said that a three notch cut of Morgan Stanley's ratings could lead to $5 billion in collateral costs and chip up to 30% from the company's bumper fixed income earnings. Many of Morgan Stanley's derivatives trading units are subject to the Moody's ratings, in contrast to competitors who have pushed such units to higher rated subsidiaries. Previous downgrades have taken markets by surprise. In a March note to clients assessing the impact of a Moody's downgrade, Nomura bank analyst Glenn Schorr calculated that on a downgrade, large bank stocks could drop between 2% to 5%.
A set of possible multi-notch downgrades may not drive banks into a capital spiral, even if they were met by similar moves at ratings agencies Standard & Poor's and Fitch, which could cost roughly a combined $20 billion for JPMorgan, Bank of America ( BAC), Morgan Stanley ( MS), Citigroup ( C ) and Goldman Sachs ( GS), as the banks have disclosed. "What we've seen with the largest banks, and U.S. banks in particular, is that their liquidity profile has improved after the crisis," said Joo-Yung Lee, the head of Fitch Ratings' North American financial institutions team, of the prospective ratings cuts, in a March 27 interview . "In blunt terms, in our view, Moody's just doesn't think it is as good an industry as they did in the past," wrote Schorr of Nomura in March, 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 may be 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. Currently, Standard & Poor's and Fitch have yet to cut U.S. bank ratings, since a series of downgrades in the second half of 2012. 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. For more on bank stocks, see Bank of America was a ratings cut loser and what Warren Buffett knows about bank investing that you don't. -- Written by Antoine Gara in New York.