JPMorgan Lead Over Morgan Stanley Widening on Rating Cuts
Potential downgrades of banks including Morgan Stanley (MS) and UBS AG, which could have their credit ratings cut by Moody’s Investors Service to the lowest level ever, threaten to shake up Wall Street’s balance of power.
Morgan Stanley and UBS may be lowered three grades, Moody’s said Feb. 15, and Citigroup Inc. (C) and Bank of America Corp. could join Morgan Stanley at Baa2, two levels above junk. The cuts would raise funding and collateral costs, making the lowest- rated firms less desirable counterparties in over-the-counter derivatives trades, according to analysts and executives.
That may push more business to JPMorgan Chase & Co. (JPM) and Deutsche Bank AG, which would be the highest-rated firms among the top nine global investment banks if Moody’s goes through with its maximum reductions. Those two firms already have the highest market share in fixed-income trading and had the biggest gains in share last year as investors grappled with fears about global contagion from Europe’s debt crisis.
“The winners are JPMorgan and Goldman Sachs, who relatively will have stronger ratings, and the losers will be Citi, Bank of America and Morgan Stanley,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York and a former treasurer at Morgan Stanley. “Lower ratings hurt the willingness of players to take my name as a derivatives counterparty, and it is in derivatives where I get some of the highest-margin businesses in fixed income.”
If Moody’s cuts each of the 17 banks it placed on review by the most levels cited in February, the separation between the top and bottom tiers of global investment banks would widen. JPMorgan, Frankfurt-based Deutsche Bank and Credit Suisse Group AG would have a rating of A2, five levels above junk. Goldman Sachs Group Inc. (GS), Barclays Plc and UBS would be one level below them at A3. Morgan Stanley, Citigroup and Bank of America would be three grades below the top group, making the spread between JPMorgan and Morgan Stanley the biggest ever.
Banks don’t expect Moody’s to make ratings changes until May, according to two people with knowledge of the matter who asked not to be identified because talks with the ratings firms are private. Moody’s may not make all or any of the cuts.
The full downgrades would result in a wider gap among banks than under Standard & Poor’s and would bring most lenders to lower ratings than S&P. That firm rates Deutsche Bank at A+, six levels above junk, JPMorgan and the three other European banks one grade lower at A and the rest of the U.S. banks at A-.
The Moody’s cuts could accelerate the separation between banks with rising market shares and those that are falling. JPMorgan, led by Chief Executive Officer Jamie Dimon, 56, is the only one of the nine banks whose trading revenue last year was greater than in 2006, while Bank of America had the biggest decline, according to figures compiled by Chris Kotowski, an analyst at Oppenheimer & Co. in New York. Kotowski’s 2006 figures included the revenue of firms later acquired by the banks, such as Bear Stearns Cos. and Merrill Lynch & Co.
JPMorgan gained clients because it was seen as one of the strongest counterparties, Jes Staley, 55, CEO of the New York- based firm’s investment bank, said at a February presentation.
“We had a significant swing in our client franchise coming out of the financial crisis because we were the safe harbor,” Staley said.
The bank generates 25 percent of its fixed-income trading in a given quarter from just 0.14 percent of trades, including some long-dated derivatives, Staley said. Those are the trades most likely to be affected by the difference in banks’ credit ratings, analysts including Citigroup’s Keith Horowitz said.
The effect of clients moving long-dated derivatives may be limited as some contracts are pushed to central clearinghouses under the Dodd-Frank Act. The business also has become less attractive to banks because of higher capital requirements tied to such trades under Basel III rules, Horowitz said.
Some Morgan Stanley employees received a four-page document last week with talking points for potential questions after the New York Times reported on the review for downgrade, said people with knowledge of the memo who asked not to be identified because it wasn’t made public.
“Morgan Stanley has done extensive planning and is fully prepared for all potential ratings-downgrade scenarios,” Mark Lake, a spokesman for the New York-based firm, said in an e- mailed statement.
Bank of America executives traveled around the world to reassure corporate clients that the Charlotte, North Carolina- based company was a steady partner after Moody’s cut the bank’s credit grades in September, co-Chief Operating Officer Thomas K. Montag, 55, said in a Jan. 19 staff meeting.
“We went through a difficult time for a couple of months where we spent a lot of time with our clients explaining to them about our balance sheet,” Montag said. “We’ve gotten through the worst of it, and this firm, and the market by the way, is telling us this, that this place has incredible potential. From this point forward, it’s a new game.”
Bank of America is rated Baa1, the third-lowest investment grade, after the two-level cut by Moody’s last year. The lender’s credit rating, which trading partners use to judge the risk of a failure to make good on commitments, now is below that of some of its counterparties, Montag said. Corporate banking clients remained loyal after the downgrade, while hedge funds may have been harder to retain, he said.
Jerry Dubrowksi, a spokesman for Bank of America, declined to comment.
“Our clients tend to be more sophisticated in their analysis than to rely solely on ratings from a single agency,” said Jon Diat, a Citigroup spokesman in New York. “While some clients might note any changes in ratings from Moody’s, we don’t believe the impact would be material.”
Lenders may have to post additional collateral or terminate derivatives contracts if they’re downgraded. The nine banks said in annual filings that if their ratings are cut by one level, they would have to put up a combined $12 billion more in collateral or termination payments. Two levels would require more than $20 billion extra. The companies didn’t disclose the impact of being downgraded by only one of the ratings firms.
The collateral requirements for U.S. banks are manageable, as they amount to less than 5 percent of lenders’ liquidity pools, Citigroup’s Horowitz said in a note to clients last week.
A greater impact on earnings may come if borrowing spreads widen after the downgrades. The nine banks have $239 billion in bonds coming due this year, according to data compiled by Bloomberg. A half-percentage point increase in the interest rate banks would have to pay to refinance that debt means more than $1 billion of extra expense.
Bank spreads have rallied since Moody’s announced the reviews, in part because of improved economic conditions in the U.S. and Europe. Credit-default swaps on five-year senior debt of the five U.S. firms in the review, which generally move in line with bond spreads, each have dropped at least 14 basis points, and Bank of America’s swaps have fallen 66 basis points. A basis point is 0.01 percentage point. The cost of JPMorgan’s swaps dropped 26 percent, while Bank of America’s fell 22 percent and Morgan Stanley’s declined 4.3 percent.
“The market has already adjusted,” said Richard Bove, a bank analyst at Rochdale Securities LLC in Lutz, Florida. “It’s been adjusting for three years. The thing that is most apparent in the market is that there has just been a staggering improvement in the quality of bank balance sheets.”
A downgrade of short-term ratings may have a bigger impact than one on long-term debt, according to analysts including Paul Smillie, who helps oversee about $43 billion of fixed-income assets at Threadneedle Asset Management in London.
Moody’s placed all short-term ratings of Morgan Stanley and Zurich-based UBS on review in February. It also put the short- term ratings of the operating companies of Bank of America and Citigroup on review, as well as the holding-company ratings of Goldman Sachs and London-based Barclays. While all the firms except Bank of America are currently rated Prime-1, or P-1, long-term ratings below A2 often lead to P-2 short-term grades.
“The repo market tends to be ratings-sensitive, and a P-2 rating may mean counterparties refuse to roll the repo or demand additional collateral or higher yields,” Smillie said.
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