A Sober New Reality in Credit Downgrades for Banks

When a consumer’s credit score drops, it is hard to recover financially. Wall Street firms could face the same fate.

Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America and Citigroup all suffered credit ratings cuts on Thursday. The rating agency Moody’s Investors Service said that, even though these banks had moved to strengthen their operations, their core trading businesses contained structural weaknesses.


In other words, the downgrades reflect the new sober era for Wall Street.

Since Moody’s put the banks on warning in February, the firms have had time to brace themselves and the immediate impact of the cuts is not likely to be drastic. But banking industry analysts say they think Moody’s actions will cause lasting pain.

“It will make life more difficult for the banks over the long run,” said Andrew Ang, a professor of business at Columbia Business School. “The effect of ratings is pervasive.”

Ratings at Bank of America, which owns Merrill Lynch, and Citigroup, which has a large investment bank, were cut to Baa2. At that level, their creditworthiness is at the lower end of the investment grade, just two levels above junk. Morgan Stanley was downgraded to Baa1, three notches above junk, and Goldman was reduced to A3, four notches above junk.

In many ways, those cuts echo investor sentiment about banks with large Wall Street operations. The stocks of Goldman, Morgan Stanley and similar firms trade at valuations that are depressed by historical standards, an indication that investors harbor deep doubts about the industry’s long-term prospects.

But the sharply lower credit ratings may cause more stress in the same areas that prompted the downgrades.

One of those trouble spots is short-term borrowing. Wall Street firms need to finance their operations at a low cost to make profits, so they make heavy use of short-term loans that last from a few days to a few months.

Since the financial crisis, banks have made great efforts to make this critical financing source safer, partly by backing this debt with higher-quality assets.

Even so, the downgrades could push up the costs of these loans. With a lower credit rating, lenders might think there is a higher probability that the banks won’t repay the money.

“These firms have large amounts of debt that they have to keep rolling over, and they will have to pay more to do that,” Mr. Ang said.

They could also feel the pain in their derivatives business. Derivatives, financial instruments whose value is linked to prices of bonds and stocks, can be a lucrative for banks, especially when they are specially tailored for the customer on the other side of the trade.

But these clients, to protect themselves, may now demand better terms with downgraded banks, like increased collateral. Wall Street firms would then have to decide whether to give up the business, or go along with client demands and face weaker profits.

“Some banks may have to relax their terms in order to win business,” said Paul Gulberg, a brokerage analyst at Portales Partners.

The downgrade could also widen the chasm in the industry. While most big banks were downgraded, some got hit harder than others. At the high end of the rating spectrum is JPMorgan Chase. Citigroup and Bank of America fall much lower down.

“The downgrades will change the competitive dynamics of Wall Street,” said Mr. Gulberg, who said JPMorgan had been steadily increasing its market share in important businesses over the last several years.

The situation could be especially acute in the derivatives.

To help insulate their profits from a downgrade, many Wall Street firms locate derivatives trades in bank subsidiaries backed by government-insured deposits. As a result, these subsidiaries have higher credit ratings than the parent companies.

Citigroup, Bank of America and JPMorgan Chase have more than 90 percent of their derivatives in such subsidiaries. Morgan Stanley only has 5 percent.

Notably, Moody’s didn’t warn of possible future downgrades for these subsidiaries. But it did say the parent companies had a “negative outlook,” the agency’s way of saying it still had doubts about their creditworthiness.

Given that threat, the banks may try to do as much business as they can in these higher-rated subsidiaries. That could face resistance, especially if bank regulators think it is risky business.

“The banks already have every incentive to use their bank subsidiaries, but it’s even greater after the downgrades,” said Dennis Kelleher, president of Better Markets, a lobbying group that is pushing for stricter financial regulations. “That’s why regulators need to be on guard and scrutinize everything the banks are doing, or moving into, these subsidiaries.”

The downgrades may also intensify competition from outside the traditional players on Wall Street. Asset managers like BlackRock are making inroads, sometimes bypassing Wall Street in the process. Bond trading, a huge source of revenue for firms like JPMorgan, is especially vulnerable.

The downgrades will only help the insurgents. For instance, Moody’s rates BlackRock A1, two notches above Goldman, and one level higher than JPMorgan.