Why Moody's cuts were good news for banks

The long-awaited downgrade could have been much worse.

By InvestorPlace Jun 22, 2012 12:28PM

By Dan Burrows

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 at the hands of Moody's (MCO) -- 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 (JPM), Citigroup (C), Bank of America (BAC), Goldman Sachs (GS) and Morgan Stanley (MS), 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, which means 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 promises to provide more than enough anxiety for the financial sector in the months and years to come.

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

More from InvestorPlace

Jun 22, 2012 2:47PM
The problem is in the root... Moody's missed the entire irresponsible credit movement. It was supposed to grade paper quality and never noticed there were no files. Thus... after blowing the whole reason for their existence, they are "rating" banks protected by the Gramm Leach Bliley Act where the aspects of rating are nebulous because there are no public rules. Further, all the downgraded banks are buried in Euro Junk Bonds. How would YOU rate non-performance and poor decision?

I disagree that the downgrades are even worthy of reporting. I'd prefer Moody's published criteria and let the public determine the rating. As for me... banks F-- FAILED and are not solvent if they are stuffed with fiat not economic-supporting currency. I would also rate their platform business clients as F-- FAILED because we need job recovery right now and they can't, because they are buried in Euro Junk bonds too.

Jun 22, 2012 3:14PM

The downgrades will mean more earnings by the Central Bankers, won't they? And those increased profits won't benefit anyone but the super rich, correct? So, won't this raise the cost of money for everyone else?

Jun 22, 2012 3:18PM
Someone should ask Romney, what he would do, if all these downgraded banks, are facing bankruptcy, in a year or two, caused by there bad investments. My guess he would bail them all out, no matter what the cost, even if it were several trillion dollars. These banks own, Romney. 
Jun 22, 2012 3:41PM
VL:  Not only are the Moody ratings arbitrary but self serving.  Remember when Enron went down the tubes and Moody's had a director on the board.  Although Jubak makes a financial case for kissing up, the fine print in the annual report and the government stress test rating is much more reveling.  JP Morgan's derivative loss was covered by undisclosed gains in several capital funds.  This is found in the back of the the annual report because you have to pay taxes on the profits if you put it up front.  And no one has mentioned the $17 billion loss the federal reserve banks took over the write down of the Greek bonds this quarter.  The next set of quarterlies should be interesting reading.
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