Why Moody’s Cuts Were Good News for Banks

by Dan Burrows | June 22, 2012 11:28 am

Why Moody’s Cuts Were Good News for Banks

Welcome to wacky world of Wall Street, where up is sometimes down and black is often white.

A total of 15 giant banks and securities firms in the U.S. and abroad suffered a credit downgrade[1] at the hands of Moody’s (NYSE:MCO[2]) — in some cases bringing the quality of their debt perilously close to junk status — and yet financial stocks rose smartly on the news.

So what’s up with that? When it comes to the market, bad news is good news when it’s not as bad as expected.

Stocks, remember, are forward-looking, theoretically because they represent a claim on future earnings. Yesterday is gone and the present is fleeting. The market only cares about tomorrow. After all, where stocks are headed is where the money’s made, whether it’s by shorting them or going long.

That’s why when Moody’s finally lowered the boom on the big banks, including JPMorgan Chase (NYSE:JPM[3]), Citigroup (NYSE:C[4]), Bank of America (NYSE:BAC[5]), Goldman Sachs (NYSE:GS[6]) and Morgan Stanley (NYSE:MS[7]), it was met with relief, and their stocks perked up.

The market, you see, had been bracing for something much worse for months, ever since Moody’s put the firms on notice back in mid-February. The agency said it was reviewing their ratings and even gave guidance as to how bad it could get. The most daunting warning was the hammer Moody’s could take to Morgan Stanley, which was looking at a potential cut of three notches to its credit score.

That really would have hurt. Credit ratings are especially important to banks. They borrow a great deal of cash and a downgrade raises the cost of their loans. They also put up great gobs of collateral in their capital markets operations, and lower a rating means they have to cough up more collateral to back up bets. That takes a bite out of profitability, since it ties up cash that could be earning money elsewhere.

But the market had four months to sweat out the ramifications of the downgrades and presumably price the possibility into the bank stocks. Now that the news has hit and — especially in Morgan Stanley’s case — wasn’t the worst possible outcome, a relief rally has predictably set in.

And so Morgan Stanley, which faced a cut of three notches but “only” got two, saw its shares jump nearly 3% in early trading. Indeed, in the words of Keefe, Bruyette & Woods analyst David Konrad, Morgan Stanley was the big winner in the Moody’s action.

More important, getting the Moody’s action out of the way lifts a huge weight off banks’ stocks, the analyst notes. No, the downgrade is by no means a good thing — but at least it’s over.

“Prior to the announcement, the markets had been unsettled, waiting for the downgrade from Moody’s,” Konrad writes in a note to clients. “This, coupled with the European financial crisis, has been the primary reason for the underperformance of the universal banks.”

Furthermore, and perhaps most important, in Konrad’s estimation the higher collateral requirements following the ratings downgrades won’t have any impact on the banks’ bottom lines.

“We don’t foresee the ratings changes to significantly alter the business lines at any of the U.S universal banks,” he says.

The trepidation is over. And the market’s biggest anxiety ahead of the Moody’s ruling — a collateral call, which could have been truly ugly — looks to be off the table. Uncertainty — one of the absolute worst things for any stock — has been lifted, and this particular headwind has petered out.

Which is all just as well. The gathering storm in the eurozone[8] promises to provide more than enough anxiety for the financial sector in the months and years to come.

Dan Burrows doesn’t hold any of the securities mentioned here.

Endnotes:
  1. a credit downgrade: http://investorplace.com/2012/06/moodys-downgrades-15-global-banks/
  2. MCO: http://studio-5.financialcontent.com/investplace/quote?Symbol=MCO
  3. JPM: http://studio-5.financialcontent.com/investplace/quote?Symbol=JPM
  4. C: http://studio-5.financialcontent.com/investplace/quote?Symbol=C
  5. BAC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAC
  6. GS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GS
  7. MS: http://studio-5.financialcontent.com/investplace/quote?Symbol=MS
  8. gathering storm in the eurozone: http://investorplace.com/hot-topics/europe-in-crisis/

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