Markets reacted wildly yesterday to Standard & Poor’s downgrade of U.S. long-term debt from AAA to AA+ due to the rising debt burden the U.S. faces and political drama that took place to raise the debt ceiling.  The financial sector bore the brunt of this bad news largely due to uncertainty about the impact of the downgrade on major financial firms. Bank of America (BAC) and Citigroup (C) took the biggest lumps on concerns over their mortgage portfolios following AIG’s unexpected lawsuit against BoA while other banks like JPMorgan Chase (JPM) and Wells Fargo (WFC) were hit to a lesser degree. Our take is that while the S&P reaction was probably overdone given the direct implications to the banks operations are small, the mortgage liabilities are a lingering risk that we should continue to watch.
Bank Stocks Get Hammered
The KBW Bank Index, composed of 24 geographically diversified banks and financial institutions lost nearly 11% of its value on Monday.  JPMorgan Chase, Citigroup, Bank of America and Wells Fargo account for more than a quarter of this index’s value. 
Bank of America stock fell by more than 20% over the day and Citigroup lost about 16% of its value. We believe that Bank of America suffered more acutely than other financial companies due to American Investment Group (AIG) announcing a $10 billion lawsuit against it, which added some fuel to an already spooked market. We discussed this in detail in a note titled Bank of America Stock Gets Double Whammy, AIG Suit a Concern.
Are Things Really so Grim?
The credit downgrade in essence reduces the value of long-term securities floated by the U.S. government primarily U.S. Treasury notes. Banks normally borrow short-term funds by pledging these Treasuries as collateral. Hence, a direct impact of the downgrade would be an increase in the assets that banks pledge as collateral. This would result in lower return on assets for the banks but definitely not large enough to warrant such a large decline in the value of their stocks.
Another thing to bear in mind is that while long-term interest rates for the U.S. are set to rise, banks primarily borrow money short-term and lend them in the long-term. So the actual interest expenses for banks will not be significantly affected by an increase in the long-term interest rates. These expenses will only be hit if short-term rates are also hiked – a possibility if the outstanding U.S. debt figure is not quickly and effectively reined in.
In addition to this, the lending businesses for banks typically do better with a steeper yield curve because the spread they can earn on their loans increases, and trading desks also tend to benefit from higher volatility normally associated with steeper yield curves.
(Chart created by using Trefis' app)
Panic and Uncertainty to Blame
We believe the decline in value across the financial sector and the market as a whole is driven more by investor uncertainty of the economic outlook than to any particular event like the credit rating downgrade.
With banks’ earnings wrapping up less than two weeks ago, restlessness in the market began with Bank of America taking huge charges on its mortgage portfolio. This led to growing uncertainty about the quality of assets held by the large banks, a belief reinforced unexpectedly by AIG’s lawsuit against Bank of America early Monday morning.
Moreover, with growing debt concerns in Europe – led by concerns of Greece and Italy spiraling out of control – and the increasing politicization of U.S.’s debt concerns, financials were spooked by the combination of the downgrade and AIG lawsuit.
- Rating Action on U.S. and Related Material, S&P
- KBW Bank Index, Bloomberg
- KBM Bank Index Details, International Securities Exchange, 30 Jun 2011