While Wall Street’s eye remains glued to bank earnings, the clock is ticking on a potentially disruptive development on three big financial firms’ profitability and share prices.
Moody’s Investors Service, one of the two big credit ratings agencies along with Standard & Poor’s, has said that in about a month from now it will decide whether to slash its ratings on 17 global financial companies, including Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Morgan Stanley (NYSE:MS).
If Moody’s goes through with the credit downgrades, the three banks would be rated Baa2, or two notches above junk grade. That sounds worse than the ultimate impact is likely to be, but a lower credit rating only adds to the obstacles the banks face in growing revenues during these days of lower deal activity and returns from trading, as well as regulatory uncertainty.
The impacts of a ratings cut would be twofold. Not only would it push up the banks’ borrowing costs — a potential problem for Morgan Stanley as it seeks to up its stake in Smith Barney — but it also would mean the companies would need to put up more collateral when making trades.
That could be a big drag on trading profits. When a bank enters into a trading contract with another entity, such as another bank or hedge fund, it has to put up collateral. A lower credit rating means the bank has to put up more collateral. It also has to pay higher interest on the money it borrows to come up with that collateral. If a trade starts to move against the bank, it has to put up more collateral, making the cost of a bad bet bigger.
As such, Bank of America, Citigroup and Morgan Stanley have said they would need to put up billions of dollars in additional collateral if Moody’s does indeed cut their credit ratings.
Of the three banks, Morgan Stanley appears to have the most to lose should Moody’s reduce its credit rating. The company purchased a 51% stake in asset manager Smith Barney from Citigroup in 2009, with an agreement that it could increase its stake by an additional 14% this year, 15% next year and 20% in 2014.
Analysts at Trefis say Morgan Stanley should accelerate the process and just acquire Smith Barney right now. The purchase price is likely only to go up, the analysts say, and it will get more expensive after a ratings cut hikes the investment bank’s borrowing costs.
“Morgan Stanley will need to raise additional capital to fund the deal,” wrote Trefis analysts in a recent report to clients. “As a going concern, the remaining 49% stake could hence cost Morgan Stanley anything around $10 billion — something the investment bank will have to specifically prepare finances for.”
Furthermore, the blows to Bank of America and Citigroup would be tempered by the case that both firms have subsidiaries with higher credit ratings whose borrowing costs and collateral requirements would be unaffected. Morgan Stanley, without such a cushion, could find it harder to compete against rivals such as JPMorgan Chase (NYSE:JPM) and Goldman Sachs (NYSE:GS).
However, should Moody’s go ahead with the downgrades, it’s hardly the kiss of death. All three firms are preparing for such an eventuality, and the market appears to be ready for any such move, too. Shares sold off when the Moody’s announced the potential news late last month. If the ratings agency goes through with the cut, any effects should already be baked in.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.
