Preparing for bank downgrades

By Felix Salmon
May 24, 2010
Mark Gongloff goes out on a limb today, saying that if the final financial regulatory reform bill passes in anything like the form passed by the Senate, "the rating companies will almost certainly lower credit ratings for some of the biggest banks".


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Mark Gongloff goes out on a limb today, saying that if the final financial regulatory reform bill passes in anything like the form passed by the Senate, “the rating companies will almost certainly lower credit ratings for some of the biggest banks”.

No one from any ratings agency is quoted in the piece, but it’s worth reading between the lines here: while the story explicitly says that “all of the banks either declined to comment or didn’t return phone calls seeking comment”, there’s no such disclaimer about the ratings agencies. So I think it’s fair to assume that Gongloff got his story straight from the agencies themselves, on the proviso that he not quote them directly.

It seems that the ratings agencies want to be ahead of the curve on this issue: Gongloff points out that there’s no indication in the markets that banks’ borrowing costs have been rising at all in anticipation of the coming bill; normally ratings agencies only downgrade after spreads have widened.

On the other hand, it’s not clear just how harmful a downgrade would be. Here’s Gongloff’s worst-case scenario:

A five-notch downgrade of Bank of America by Moody’s to Baa2 from Aa3, the equivalent of an S&P rating cut to BBB from AA-, could raise the interest-rate spread over Treasury yields that the bank must pay to borrow by 1.43 percentage points, according to prevailing market rates on Friday compiled by S&P.

That could add $2.38 billion to Bank of America’s annual interest expense, assuming the bank’s long-term debt rises by a net $170 billion a year, as it did in 2009.

For one thing, no one’s going to downgrade BofA by five notches: it’s still too big to fail, after all. And according to BofA’s annual report, its total interest expense last year was already $30.8 billion: adding $2.38 billion to that would be a blow, but hardly an enormous one, given that the bank’s interest expense in 2008 was $40.3 billion, and in 2007 was $52.9 billion.

But in any case, there’s simply no way that BofA would ever allow itself to get downgraded to anything with a B handle, and if that did happen then we would be back in fully-fledged crisis mode. Certainly the bank wouldn’t be blithely increasing its long-term debt by $170 billion a year: rather, it would be deleveraging as aggressively as it possibly could. And its spreads would have gapped out by much more than 143bp.

It’s also worth noting that if credit ratings are pretty useless things most of the time, they’re particularly useless when it comes to banks. Remember when Moody’s upgraded every bank in Iceland to triple-A status in February 2007?

So I take this story as a warning to the banks to position themselves for downgrade risk, if and when a final bill gets passed. But I don’t think that any downgrades — which will probably be only one notch, in the first instance — are going to make much of a dent in their borrowing costs.

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Comments
4 comments so far

Don’t forget ratings based collateralisation and termination triggers – the proximate cause of AIG’s downfall.

Posted by patricio | Report as abusive

This is interesting Felix. I am going to send a note to myself to remember it.

Posted by RHS | Report as abusive

Felix, you may be interested in this piece over at the FT’s Alphaville, quoting a vague Moody’s report and a note from Barclay’s Capital on the repo implications of a downgrade: http://ftalphaville.ft.com/blog/2010/05/ 21/239976/of-reform-us-bank-ratings-and- repo/

Posted by JohnBarrdear | Report as abusive

The mistake here is to assume that downgrades have a linear affect. As Patricio stated there is probably a number of step-up clauses in their debt covenants and it will have serious knock-on effects in the money and repo markets in terms of their ability to raise ANY capital in those markets.

Yet another one of those unintended consequences and what happens when you pass poorly thought out regulation on the back of populist rhetoric.

Posted by Danny_Black | Report as abusive
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