Article by Investment U
What’s the premise behind this whole downgrading business?
“Hindsight is 20/20.”
“Fool me once, shame on you. Fool me twice, shame on me.”
We’ve all heard these adages before – and so has Moody’s. Let’s go back to the mid-2000s…
There were a number of banks out there investing in a lot of things that rating agencies couldn’t comprehend. Since there was an inability to assess risk, agencies such as Moody’s gave AAA ratings to banks like coaches giving out trophies at a YMCA youth sports tournament –everybody was a winner.
We know the results of that process. Banks took on a lot of risk and didn’t have the capital requirements to back it all up. It all hit the fan four years ago and rating agencies lost massive credibility.
Last week, Moody’s made the attempt to regain some of that lost prestige. But the markets basically told them, “We already knew this.” Markets took little notice after Moody’s downgraded the ratings of 15 of the world’s largest banks. We all knew it was coming.
So, was there anything new we learned from the latest downgrades?
Dividing Banks into Three Tiers
One of the biggest problems that wasn’t addressed four years ago was how banks would deal with certain financial crises. Remember that the Federal Reserve did stress testing with some of the bigger banks a few months back to see how they would do against a European banking collapse and other economic fiascos. Well, Moody’s looked at the same thing when it downgraded banks.
With their ratings downgrades, Moody’s Investors Service further divided some of the world’s biggest banks. The divisions are based on each bank’s strength and if it can weather storms with access to cheap customer deposits. And this makes sense.
“Safe haven” banks are those institutions that fund themselves with steady retail deposits rather than the climate in capital markets. Moody’s designated its highest ratings to three safe havens – HSBC (NYSE: HBC), Royal Bank of Canada (NYSE: RY) and JPMorgan (NYSE: JPM) – because it argued that these three are protected by their deposits and thus have an edge to absorb hits better than their peers.
A new trend that evolved after the banking crisis is weaker banks with less “shock absorbers” getting hammered for taking risk. Meanwhile, stronger banks are rewarded for being more conservative, guaranteeing lower costs and greater margins.
Those banks with lower ratings will not only see their cost of business increasing (i.e. through reduced access to funds or by paying more for funding), but could see trading partners ask for more collateral. Most likely, you’ll see a lot of business guided to banks that the market perceives as stronger. If you’re a bank that’s severely dependent upon markets for funding, the lower your rating, the harder it is to get that funding because of the debt crisis in Europe and the worldwide economic slowdown.
Just in case you’re curious, there were three tiers of strength. I’ve talked about some the strongest, but there’s the middle tier. Moody’s said these banks depend on unreliable capital market revenues to make shareowners happy. Goldman Sachs (NYSE: GS) fell into this group.
The last group is those that had been roughed up by their risk management and/or have “shock absorbers” not up to par with their banking peers. Morgan Stanley (NYSE: MS), Bank of America (NYSE: BAC) and Citigroup (NYSE: C) were all placed here.
Downgrades May Be An Opportunity for Regional Banks
People yelled that these banks were too big to fail. But what about all the other banks? How are they affected by Moody’s rate cuts?
That’s a good question, because there should be an opportunity here. Enter the big regional banks such as:
- U.S. Bancorp (NYSE: USB)
- PNC Financial Services (NYSE: PNC)
- BB&T (NYSE: BBT)
Don’t get me wrong, they take hits like the big boys do. They move in step with the economy and fall prey to the same information and economic influences. However, the big regional banks don’t possess all the complicated trading practices or the derivative operations that are still so secretive. These are some of the reasons for the downgrading of the global banks. They also started to and are expected to take more market share in areas like commercial lending from bigger banks.
Also keep in mind that the banking sector has been undervalued for a while. David Sterman for Financial Adviser reported at the beginning of the year that analysts were stating that bank stocks were cheap and that the financial services sector was bound for a rally. For instance, The Oxford Club’s Trading Portfolio is even sitting on a 58% gain with its position in BB&T – since Alexander Green recommended it in August of 2011. And remember, Warren Buffett’s bets in Wells Fargo (NYSE: WFC) and Bank of America last year are starting to pay off.
Points Worth Noting…
- I think that investors have seen the appeal of value in banks and the financial sector. The investment is worth the money according to the fundamentals. Look for movement into the sector by means of the larger regional banks – such as the ones mentioned above.
- Regional banks also look to be a bargain on terms of trailing profits and/or book value.
- For some safety in diversification, investors could look at some ETFs to possibly alleviate some of the risk in individual bank stocks. One of the more affordable ones is the SPDR S&P Regional Banking ETF (NYSE: KRE). While it has an expense ratio of .35%, it’s a lot cheaper than its peers and it has exposure to a bigger spectrum of regional banks.
Good Investing,
Jason Jenkins
Article by Investment U
