Big U.S. Banks Brace for Downgrades

Banks, bond issuers and investors are bracing for aftershocks from a wave of bank downgrades expected to hit the U.S. as soon as the coming week.

Moody's Investors Service has said it is likely to reduce by the end of June credit ratings for 17 large global banks, including five of the six biggest U.S. financial firms by assets. The downgrades are expected to raise borrowing costs and crimp some lucrative trading businesses at the banks, including at JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Goldman Sachs Group Inc. and Morgan Stanley.

The ratings adjustments also could affect how municipalities raise money to provide services and build schools, how money-market funds invest cash from companies and savers, and how banks raise capital to support their lending and trading. Already, money-market funds are curbing some lending to banks, and cities and states are switching bankers.

The impending downgrades are adding to the unease already plaguing banks, investors and borrowers. Financial markets are on edge as the European debt crisis deepens and the likelihood grows of a Greek exit from the euro zone. Economies in the U.S. and China are showing signs of slowing.

Many debt investors have rushed into safe-haven assets such as U.S. Treasurys and are avoiding any investments that have even an inkling of risk.

The ratings action has been in the works since February, when the Moody's Corp. unit said it would review the credit ratings of more than 100 banks around the world because of pressures on bank profits. Those threats include uneven economic growth, nervous financial markets and tighter regulations. A Moody's spokesman declined to comment.

While banks and investors all anticipate downgrades in the coming week, many banks have lobbied Moody's to limit the size of its cuts. The market has also had months of warning, potentially limiting the immediate impact of any downgrades.

The $2.6 trillion money-market-fund industry is likely to be particularly affected. Those funds are restricted by law in what they can buy, and typically must have the bulk of their holdings in the most highly rated short-term debt -- rated Prime-1 by Moody's. That includes everything from commercial paper sold by the world's biggest banks to some forms of debt sold by municipalities.

Moody's is considering lowering ratings on the short-term debt of the main banking units of companies such as Bank of America and Citigroup, from Prime-1 to a second-tier rating of Prime-2. That would make their debt less attractive, and in some cases off limits, to money funds.

"Every time Moody's downgrades, it's going to lower our universe of what we can buy," said David Fishman, co-head of global liquidity management for Goldman Sachs Asset Management.

Money-market funds have become more reluctant recently to lend to banks in the U.S. and Europe. Many funds are only willing to lend on an overnight basis to banks on review for downgrade, and they are shunning banks that suffer large downgrades.

"Over the past few weeks, some investors have shortened the tenor of lending to banks both within and outside the euro zone," said Chris Conetta, global head of commercial-paper trading at Barclays PLC in New York. "Many who had been buying paper in the six-month area have recently focused their lending to three months and shorter."

Overnight loans made up 31% of assets at U.S. prime-money-market funds at the end of April, according to Fitch Ratings. That is the highest percentage since Fitch began tracking such data in 2010, and up from 28.4% in March.

As money funds reduce their investments in commercial paper, banks lose a crucial form of funding. The loss could be offset by the fact that banks are flush with deposits and have been shifting their funding sources in anticipation of downgrades, market participants said. Many banks have also curtailed their short-term borrowing since the financial crisis.

Across the U.S., cities, states and other municipalities have been racing to avoid becoming collateral damage.

Bank of America, Citigroup and other banks are big backers of a kind of municipal debt known as variable-rate demand bonds. If those banks are downgraded, the bonds will be, too, pushing up interest costs and lowering the debt's value. Spokesmen for Bank of America and Citigroup declined to comment.

In Cleveland the city's debt manager, Betsy Hruby, raced to replace Bank of America as the backer of $90 million of water-department bonds. "We realized that might have an impact on the rate" of the bonds, she said.

Ms. Hruby turned to Bank of New York Mellon Corp., which isn't under Moody's scrutiny.

Other municipalities are seeking additional ratings from other ratings companies such as Moody's rivals Fitch or Standard & Poor's, which aren't planning to downgrade the banks anytime soon.

The Pittsburgh Water and Sewer Authority asked Fitch to rate about $73 million of variable-rate bonds it sold in 2008 backed by Bank of America, according to Stephen Simcic, acting co-executive director at Pittsburgh Water.

That gave the authority a third rating, along with S&P and Moody's. The extra rating means the bonds now have at least two top short-term grades, offsetting any impact from a Moody's downgrade.

Getting an extra rating "was one option we could pursue quickly without too much pain," said Mr. Simcic. "We thought it was a prudent measure."

Investors in such debt are preparing for the changes.

Craig Mauermann, who manages the $850 million BMO Tax-Free Money Market Fund, said he recently has been buying municipal bonds backed by banks "not under the gun," while selling bonds in danger of being hit by a downgrade.

"We manage the most conservative type of investment there is in the world," he said. "We continue to reduce risk in all ways we can."

Some banks have estimated some of the direct costs of a Moody's downgrade, such as additional collateral they would have to post or termination payments they would make.

In its first-quarter financial report, Morgan Stanley said it could pay as much as $9.6 billion for a three-notch downgrade by multiple rating agencies. Goldman Sachs said its costs could hit $2.2 billion for a two-notch reduction, and Bank of America said a one-notch downgrade could deliver a $2.7 billion hit.

The biggest impact could be to deprive some institutions of trading revenue. A three-notch downgrade of Morgan Stanley could slash demand for derivatives, a crucial business on Wall Street, by around 30%, estimates Alliance Bernstein analyst Brad Hintz.

The downgrades would mean that Moody's ratings for the five U.S. banking giants are the lowest of the three major credit-rating firms. While Moody's has given the market plenty of notice, some investors worry that action by Moody's could precipitate downgrades by S&P and Fitch.

"The Moody's action is concerning because it's the beginning of what you might continue to see," said James McCarthy, co-head of global liquidity management at Goldman Sachs Asset Management.

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