Senate Bill’s Passage Raises Concern for Banks’ Credit Ratings

A Senate vote to back legislation that bans the U.S. government from rescuing failing banks will test whether credit rating companies impose threatened downgrades on lenders such as Citigroup Inc.

Standard & Poor’s said in February that the removal of implicit government support by Congress would probably lead to downgrades on some banks. The Senate’s financial regulation bill gives the Federal Deposit Insurance Corp. the power to unwind failing financial firms and explicitly bars the use of taxpayer funds to rescue them.

Citigroup, Bank of America Corp., JPMorgan Chase & Co., Morgan Stanley, and Goldman Sachs Group Inc. say in filings they would have to post a total of at least $8 billion as additional collateral or spend to terminate trading deals if their ratings were cut one level. Banks may also have to change their funding plans if the cuts affect short-term ratings, which would limit their ability to issue commercial paper.

“The future enactment into law of such a sweeping piece of legislation is likely to have rating implications,” Robert Young, a managing director at Moody’s Investors Service, said today in a statement. “An issue of particular focus will be resolution authority and how that will be implemented. This will influence our views about ongoing support for systemically important institutions.”

Moody’s won’t make immediate changes to any U.S. bank ratings, it said in the statement. The company will announce a formal review of any ratings prior to a downgrade if it determines the “likelihood of support” by the government is diminished.

Regulatory Overhang

“This will likely be one more overhang that will play out later,” said William Fitzpatrick, a financial-industry analyst with Optique Capital Management, which oversees about $800 million. “We need to let things shake out first in terms of seeing just how damaging regulatory reform is to the funding costs of the large banks.”

Bank of America, Citigroup and Morgan Stanley all hold long-term ratings of A that reflect the impact of government backing. That’s three levels above the banks’ stand-alone ratings, S&P has said. Goldman Sachs’s A rating is two levels above where it otherwise would be, according to S&P.

Analysts including CreditSights Inc.’s David Hendler said they doubt Moody’s and S&P will cut their rating. “Given ratings agencies’ multiple issues in recent years, from doing a poor job and enabling the credit crisis and then compounding it with multiple downgrades, do they want to do that again to the big banks?” he said. “Theoretically they may want to go down, but to avoid lower commercial paper rating they may not want to cut the ratings.”

Morgan Stanley

Morgan Stanley spokesman Mark Lake declined to comment. Goldman Sachs spokesman Michael DuVally and Bank of America spokesman Scott Silvestri didn’t return calls seeking comment, as did Citigroup spokesman Jon Diat and JPMorgan spokeswoman Kristin Lemkau.

The Senate bill mandates that the costs of unwinding firms be borne by the financial industry. It allows the Fed to use its emergency lending authority to help only solvent firms. Congress would have to approve the use of debt guarantees. Regulators could also ban managers and directors of failed firms from working in the financial industry. The legislation still requires reconciliation with a bill passed by the House of Representatives in December.

Bank of America

In February, S&P cut its outlook for Bank of America and Citigroup to negative from stable because of uncertainty about the government’s willingness to repeat a bailout. The same month, Moody’s cut its ratings on preferred shares of Morgan Stanley by three notches and of Goldman Sachs by one as it removed the assumption of government support for those securities.

Bank of America said that a one-level downgrade would require additional collateral and termination payments of $1.8 billion related to derivatives and trading agreements. Morgan Stanley said counterparties could demand $1.6 billion in additional collateral or termination payments based on a one-level downgrade, while Goldman Sachs estimated $1.5 billion of such payments and JPMorgan said it could have to post $1.4 billion of collateral.

Citigroup said that if each of its legal entities were downgraded one level, it would have to post $2 billion of additional collateral on derivatives. All the banks made the estimates in quarterly reports to the Securities and Exchange Commission.

If long-term ratings drop below the A level, the rating companies will likely have to cut banks’ short-term issuer ratings to A-2 at S&P and P-2 at Moody’s, Hendler said. That could cause Citigroup to lose about $14.4 billion of funding options, while Bank of America’s potential lost funding would be “material,” according to regulatory filings from the banks.

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