Could U.S. Downgrade by S&P Spur Cascade Effect?

WASHINGTON — The historic downgrade of the U.S. government's credit rating is raising the question of whether similar actions may be in store for the country's largest banks.

Some argue such an outcome is inevitable because several big banks enjoy the perception of "too big to fail," which might be affected by the debt downgrade.

So far, however, Standard & Poor's Ratings Services, which for the first time in history downgraded the U.S. on Friday, is attempting to put the question to rest.

"Lowering of the United States of America sovereign credit rating to 'AA+' from 'AAA' does not have an immediate or direct impact on our ratings on U.S. banks," Stuart Plesser, credit analyst for S&P, wrote in a note on Monday. "None of the banks we rate in the U.S. has an issuer credit rating higher than the U.S. sovereign rating."

Specifically, S&P said the downgrade would "not alter the government support assumptions" it factors in when rating four banks. S&P did not name the banks.

Despite claims by regulators and President Obama that the Dodd-Frank Act effectively ended too big to fail, S&P President Deven Sharma testified last month that the firm continues to factor the likelihood of government support into its ratings of banks.

Standard & Poor's first assesses a bank's standalone credit risk, but then also factors in "what external support it may be provided" by the government," he said at a congressional hearing on July 27.

If a large financial institution were to falter, "we think, based on the history, based on the size of the banks and the connectivity, that there may be attempts at changing the policies to support the banks in the future," Sharma said.

S&P issued the terse statement just shy of the closing bell after a volatile market sell-off, which left many bank stocks hemorrhaging. Bank of America Corp. closed at $6.51, after falling $1.66, shedding more than 20% of its value.

If other ratings agencies downgrade the U.S., however, the situation may be different for big banks.

Moody's Investors Service has raised more alarm on the issue, signaling last month that even placing the country's debt rating on review for possible downgrade could have consequences for the ratings at eight U.S. financial institutions.

"A downgrade of the U.S. government could put additional pressure on these ratings," Brian Harris, a Moody's analyst, wrote in a note to clients on July 13. "However, in some cases systemically important banks may be rated higher than the government debt rating under Moody's bank rating methodology, because governments and central banks have an array of tools — financial as well as non-financial — to assist banks even when the government itself is having difficulty servicing its debt."

Three of the institutions are already on review for a possible downgrade by Moody's, including Bank of America Corp., Citigroup Inc., and Wells Fargo & Co. Each receives an uplift in a range from three to five notches above their baseline credit assessments reflecting "the unusual degree of support each banks received during the crisis," according to Moody's.

The other five banks — State Street Corp., Goldman Sachs, Morgan Stanley and JPMorgan Chase, are limited by Moody's to only one or two notches higher over the baseline.

"To the extent that you had AAA-rated bank … and on a standalone basis it was rated Aa, that two notch lift is coming from external [government], so if the government is downgraded well, that's going to put pressure on the bank rating," said Harris in an interview Monday.

Harris declined to comment on whether he anticipated future downgrades of banks in the coming weeks.

For its part, Fitch Ratings has previously dismissed the possibility of putting banks on a possible review in the event of a negative Rating Watch.

"Most U.S. banking institutions remain relatively highly liquid, are self-funded, and are not dependent on the U.S. government to fund their day-to-day operations," James Moss, Fitch analyst wrote on July 18. "However, market responses to the evolving situation could create challenges for banks and such challenges could impact our assessment of credit worthiness."

Still, not all investors were convinced, saying a domino effect would be highly likely.

"I am sure we are going to see S&P starting to do some trickle-down downgrades of some of the largest institutions," said Neil Barofsky, ex-special Inspector General for the Treasury Department's Troubled Asset Relief Program and now a professor a New York University. "It would be logical since if they are giving them an updraft based on the presumption of a government bailout I don't know how you could downgrade the U.S. and not do a follow on downgrade of those institutions."

Such a downgrade would be even higher if other agencies followed suit in downgrading the U.S. sovereign debt.

"To the extent that the larger banks are joined at the hip, now as a result of the implied guarantee, of their obligations, I would expect them to move in tandem with the sovereign debt," said Cornelius Hurley, a banking law professor at Boston University and a former Fed lawyer.

Some observers said it would take more than a downgrade of the U.S.' credit rating to prompt further actions on the banks.

"I think it's certainly appropriate to look at the large institutions, and given everything that's gone on in the marketplace today, but not solely because of the U.S. debt issue. I think it would be erroneous for the credit agencies to draw any conclusions just because of what's going on with U.S. debt," said Kevin Petrasic, a partner with Paul, Hastings, Janofsky & Walker LLP.

Banks already took a hit on Monday when S&P lowered its ratings from AAA to AA+ on debt guaranteed by the Federal Deposit Insurance Corp. under an emergency program for banks, which was established during the 2008 financial crisis.

As of June 30, 2011, there was $239.5 billion in debt outstanding to 66 bank issuers under the FDIC's program. According to the most recent data provided by SNL Financial, Citigroup had $48.0 billion in debt outstanding under the program, JPMorgan Chase had $30.6 billion, Bank of America had $27.5 billion, Morgan Stanley had $20.0 billion, and Goldman Sachs had $13.3 billion.

Kate Davidson and Kevin Wack contributed to this article.