As was long foreshadowed, Moody’s rating service has cut the ratings of just about every large U.S. banking firm last Thursday. Although the banks opened lower to start off the week, the share prices were relatively stable during the days of the Moody’s announcement. Primarily because the ratings cut have been priced in as it was public knowledge for some time now that Moody’s was going to go through with a downgrade.
What issues does a rate cut present? Well, it primarily affects institutional investors; most pension funds, endowments, etc. require that their capital is allocated to bonds and equity of investment grade entities. However, when a downgrade of this magnitude occurs, the pensions and endowments are no longer able to hold assets that are not investment grade due to the legal requirements of the funds and are forced to sell any of their holdings that do not meet the criteria.
The problem for the banks is that after a downgrade their cost of capital goes up, so it costs more money to run day to day operations, therefore, firms have to tighten up their policies on how to deploy their capital as it becomes more scarce. Another factor is that banks will have to post higher collateral when entering into new contracts.
Moody’s is saying that these downgrades are primarily based on capital requirements and the results of stress testing the banks for potential systemic shocks. However, if you think about it, most banks that have been working over the last few years to become compliant with the tiered Basel liquidity standards are now for the most part much better capitalized than they were before 2008 when their ratings were high. Part of me thinks that this is an aggressive move by Moody’s to ensure that they don’t get burned like they did by the AAA rated sub-prime mortgage CDOs back in 2007 more than any structural fault that they see in the banks.
Finally Business Week reports that Moody’ is planning to cut the ratings on several Spanish banks, for the second time in less than six weeks. There is a ton of chatter on the various finance forums and media outlets regarding these downgrades and many experts have different consequences that are a result of bank downgrades. Do you all think that the downgrades are a bunch of fluff? Or are there other negative issues that they will possibly cause other than what I have mentioned?