S&P's Downgrade of Financials Is a Definitive Bear Signal

In a press release issued on Friday, Standard & Poor’s belatedly acknowledges that the credit quality of 12 major US and European financial institutions is now reliant on ongoing access to government support mechanisms. And, for the first time, the rating agency outlined the distinction between government-induced survival on one hand and the ability to generate meaningful shareholder returns on the other.

For traders, the S&P press release qualifies as a definitive bear signal on Bank of America (BAC), Barclays (BCS), Citigroup (C), Credit Suisse (CS), Deutsche Bank (DB), Goldman Sachs (GS), HSBC (HBC), JPMorgan Chase (JPM), Morgan Stanley (MS), Royal Bank of Scotland (RBS), UBS AG (UBS), Wells Fargo (WFC) and financial-sector ETFs (PFI, IYF, VFH, XLF). The primarily reason attributed to the rating downgrades and outlook cuts was the deteriorating credit environment and, in that regard, there is little doubt that the press release was loaded with wisdom in hindsight. But it is in S&P’s assessment of “stand-alone” (i.e. without government help) creditworthiness that one finds real cause for concern. Because it is this stand-alone credit quality which has a direct bearing on equity valuations and earnings capabilities.

While conceding that core business model-related issues are still evolving, and that the process of lowering leverage within the financial sector will have a telling impact on profitability, S&P appears to be falling into the same finger-in-the-dyke mode as the Fed and the Treasury. “During the next several years we expect the stand-alone assessments and the ICRs (Issuer Credit Ratings) to converge, reflecting the progressively decreasing expectation of government support as stability returns to the markets and existing funding and government support programs run off,” S&P states in its concluding remarks. However, S&P provides no basis for its conclusions regarding convergence and the “several years” perspective offers no credit-quality insight whatsoever.

The need to segregate an issuer rating from the stand-alone rating has obviously been triggered by FDIC-guaranteed debt which is, in any event, being traded at much lower spreads than stand-alone bonds. But in view of the common assumption that the governments are not going to let the 12 downgrade targets fail, the use of the term “stand-alone” may mislead equity players. For all practical purposes, most of the 12 financial institutions would not be in business today without government assistance. So the yields on their stand-alone paper are no indicators of future share prices.

Rather, it is the inability (even at this stage) of S&P and, for that matter, other rating agencies, to establish the structural balance between deteriorating asset portfolios, de-leveraging, operating margins and capital-adequacy that should create genuine concerns for those who are currently holding shares in financial institutions. Nobody should be buying shares in these financial institutions when even business model-related issues remain unresolved. In fact, the only actionable inference which can be drawn from the S&P press release is that the overall credit outlook is not only deteriorating but that the sheer complexity of that outlook is defying all conventional wisdom; while S&P forecasts that the unemployment rate will touch 8.5% next year, it provides no specifics on the potentially more contentious problem of underemployment.

Therefore, what S&P says, and leaves unsaid, in its press release continues to make a persuasive case for short positions. Besides running the “several years” risk, those who stay invested in banks from this juncture are exposed to both deterioration and complexity. If the hoped-for “convergence” does not materialize by late-2009 or early-2010, and there is no evidence that a convergence will materialize at all, shares in financial institutions will be subject to a new set of rescue-type solutions (e.g. write-downs, mergers and takeovers), all of which will inherently incorporate unprecedented dilution for existing shareholders.

Disclosure: Author holds short position in XLF, GS, C

Comments

[Ree:]

It really matters little what the "stand alone" ratings are. If the debts are guarenteed by the government, they are as good as golden for now. Who's really going to be able to see three years down the road? As long as the banks survive, somebody's going to find some ways to make a lot of dollars. If you are investing for the long term, they are so cheap that whatever risks are worth taking. If you are just trading, both long and short positions are fun to play with.

The worst kind of bet is to "keep shorting them because the numbers don't add up". You'll learn a hard lesson: Economics is not just about pure numbers, it's about people, time and policies as well.

2008 Dec 22 04:30 AM

[investor88:]

I think Rakesh has made a good case for shorting financials like GS, C.

I must salute Rakesh for taking short positions with good reasons in GS, C. This is going against the giants ie sovereign wealth funds and Warren Buffet who said cash is trash, and invested in GS, C. Although Rakesh is up against the giants, he has a good chance of being right.

2008 Dec 22 07:44 AM

[samrock001:]

Cover up your GS shorts, else its gonna blow your a** off. Remember what happened last week.

2008 Dec 22 09:01 AM

[Daryan:]

You are a day late and a dollar short on this trade. When an entity has an implicit guranatee by the largest financial institution in the world (you and I), they quickly come off the short list. Shorting financials is a death trap at this point, best of luck.

2008 Dec 22 09:22 AM

[svosavvy:]

I whole heartedly agree with the sentiment of the article and the cautious tone of the responses. Shorting financials could be really dangerous here. After all equities rise and fall through the whims of mr market, not raw data.

2008 Dec 22 10:19 AM

[monday1929:]

At this late date, why not short the "unprotected"? The Treasury will not be able to bail-out the Russell 2000.
And why are these people not in prison yet?

Jan 06 11:50 AM