Moody's ratings cut for giant banks: a new weight on US economy

Moody's downgrade of the US banking system, following turmoil in Europe's banking sector, is a blow to reputation of banks but is not expected to tip the economy into recession.

Moody's Investors Service's decision on Thursday to downgrade the debt of 15 global banks and securities firms is yet another weight on the flagging US economy.

That’s because the cost of doing business for these giant financial institutions such as Citigroup, Bank of America, and J.P. Morgan Chase, will go up as result of having their rating lowered. The banks will then either pass along their higher costs — such as the higher interest rates they will have to pay to borrow money — or will have lower profits which will again inhibit their ability to lend.

“The Moody’s downgrade is not a positive for anyone,” says Sung Won Sohn, a professor of finance at California State University, Channel Islands, and a former banker. “The lower ratings means their ability to lend will diminish.”

RECOMMENDED: Recession in America: 10 questions assessing the threat

However, some analysts doubt that the Moody’s action by itself will tilt the economy into a recession.

“The downgrade itself is not a waterfall event nor will it trigger a sudden decline in economic activity,” says Fred Dickson, chief investment strategist at D.A. Davidson & Co. in Lake Oswego, Oregon. “A few marginal borrowers may be turned down for loans at best.”

Mr. Dickson worries that the downgrade is yet another psychological hurdle for consumers. After watching some of the largest banks in the nation have their debt downgraded, consumers may decide to hunker down. “I think there is more psychological damage than real damage,” he says.

Moody’s downgraded the long-term senior debt ratings of four banks by one notch, while the ratings of 10 financial companies were downgraded by two notches, and one firm had its ratings lowered by three notches. A notch is simply a credit level.

A bank's credit rating is an important indication of what outside organizations think of it.

“In the wake of the Moody’s downgrades, the banks reputational risks has suffered,” says Mr. Sohn. “For financial institutions reputation is very important.”

Many analysts had been worried that Moody’s would lower the debt of Morgan Stanley by three levels. Morgan Stanley’s executives had argued that the firm had strengthened its finances and should not get that steep a cut. Moody’s, in lowering Morgan Stanley’s debt by two notches, noted that the financial firm was helped by the deep pockets of one of its investors, the Mitsubishi UFJ Financial Group, and the belief that Morgan Stanley would be deemed too big to fail and thus get the support of the US government, if it were in danger of defaulting on its debt.

All of the banks that were downgraded by Moody’s are deeply involved in the global capital markets. “These activities can provide important ‘shock absorbers’ that mitigate the potential volatility of capital market operations, but they also present unique risks and challenges,” wrote Moody’s Global Banking Managing Director Greg Bauer in Moody’s review.

Those risks and challenges have been illustrated by the travails of J.P. Morgan Chase, which has already said it lost at least $2 billion in a series of complex trades that turned bad. J.P. Morgan’s CEO, Jamie Dimon, has had to apologize to the firms’ shareholders and been questioned — and sometimes tongue-lashed — by members of Congress in two recent committee hearings.

Sohn points out that the only major bank that was not downgraded by Moody’s was Wells Fargo which is mainly in the consumer banking business.

The rating downgrades had been expected, since Moody’s had indicated three months ago it was looking more closely at the banks and financial institutions and would issue a report by the end of June. Nevertheless, the stocks of the banks dropped sharply on Thursday as rumors began to swirl that Moody’s was about to issue its report after the markets closed. Many of the banks’ stock prices fell between 2 to 3 percent.

This drop has prompted David Kotok, the Chief Investment Officer of Cumberland Advisors  of Sarasota, Fla. to decide to buy bank stocks. “The banking system is for sale below book value,” he says. “That’s cheap.”

On Friday morning, it appeared that other investors also agreed that the market looked like a bargain. After falling 250 points on Thursday, the Dow Jones Industrial Average was up 76 points at 10 a.m. on Friday, and bank stocks rebounded as well. 

However, the downgrade of the banking system comes at a time when investors are still nervously watching European authorities attempt to cope the need to provide more capital to many of the continent’s banks. On Thursday, for example, Spain said its banks would need another $78.75 billion in new funding.

On Wednesday, Federal Reserve chairman Ben Bernanke said the Fed was watching the European banking situation closely. The turmoil in Europe was one of the reasons why the Fed lowered its estimate of economic growth in the US for 2012 by 0.5 percentage points and for 2013 by 0.3 percentage points. The Fed also said it would continue a program of selling some of its short term investments and buying longer term bonds in an effort to lower interest rates over a longer period of time.

However, Wall Street was generally disappointed by the Fed’s move. “It was tepid,” says Mr. Kotok. “We’re not out of the woods yet."  

RECOMMENDED: Recession in America: 10 questions assessing the threat