Raymond James Weekly Update: Market Views Banks as Less Risky After Downgrade

Raymond James Bond Market CommentaryDefiance
By Benjamin Streed
June 25, 2012

Last Thursday, Moody’s Investor Services delivered on its promise to review the long-term credit ratings of many of the world’s largest global financial institutions and lowered the ratings of Bank of America, Barclays, BNP Paribas, Citigroup, Crédit Agricole, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan, Morgan Stanley, Royal Bank of Canada, Royal Bank of Scotland, Société Générale, and UBS. Recall that in February, the ratings agency placed these 15 global banks under review for potential downgrade after it listed such risks as “higher credit spreads” and “more fragile funding conditions” amongst a laundry-list of perceived challenges for these institutions. These institutions were singled-out as they all share business models that rely heavily on capital markets activities and Moody’s made clear that it views this line of business as “volatile” and that it carries with it a “risk of outsized losses”. Remember, back in March the Federal Reserve initiated another round of so-called “stress tests” for many of the largest U.S. banks and concluded that 15 of the 19 tested could maintain sufficient capital levels amidst another recession, continued stock repurchases, larger dividends and further housing market deterioration. Coincidentally, between the initiation of the review back in February and the conclusion last week, JPMorgan announced its now infamous “whale” derivatives trading losses out of its London offices. In an “I told you so” moment, Moody’s jumped at the opportunity to remind the world that this type of event, “Exemplified some of the issues, and exact issues, that we highlighted back in February when we began the review around opacity of risk and the potential for tail risk and the difficulty in risk managing some of these firms.”

Every one of the 15 banks received a lowering of their long-term credit rating with four firms having their debt cut one notch, ten were downgraded by two notches, and only a single firm had a three notch downgrade. The cuts to U.S. banks were the following: (Old Rating to New Rating): Bank of America (Baa1 to Baa2), Citigroup (A3 to Baa2) JPMorgan (Aa3 to A2), Goldman Sachs (A1 toA3), and Morgan Stanley (A2 toBaa1). Other affected global institution were: HSBC (Aa2 to Aa3), Royal Bank of Canada (Aa1 to Aa3), Credit Suisse (Aa2 to A1), BNP Paribas (Aa3 to A2), Crédit Agricole (Aa3 toA2), Deutsche Bank (Aa3 to A2), Société Générale (A1 to A2), UBS (Aa3 to A2), Barclays (A1 to A3) and Royal Bank of Scotland (A3 to Baa1) all received downgrades as well. Moody’s left all of the U.S. banks it downgraded on a negative outlook, indicating that their credit ratings may be cut again as it cited the uncertainty over continued government support. It noted that bondholder bailouts are becoming “less predictable” because of the “evolving attitude” of policymakers.

 
Where this situation truly becomes interesting is the effect, or non-effect, it had on each company’s credit default swap (CDS) rates after the announcement. As a reminder, a CDS contract rises as investor confidence deteriorates and falls when confidence is greater. Morgan Stanley, the sole U.S. bank at risk of a three notch downgrade witnessed its 5-year CDS contracts fall nearly 30bp on Friday to 353bp, marking its lowest level since late April and is well off its recent high of over 450bp earlier this month. Bloomberg data show that the average 5-year CDS rate on the 15 affected banks fell by roughly 7bp on Friday from 247bp to 239bp, indicating a market perception of lowered risk. The market’s apparent relief translated to other CDS rates for all of the U.S. banks involved in the review; Bank of America (-9bp to 265bp), Citigroup (-9bp to 244bp) and Goldman Sachs (-18bp to 280bp).
Disclaimer:
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section ofinvestinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

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