Moody's cut the debt ratings of 15 banks and securities firms late last week, including Citigroup (C), Bank of America (BAC), J.P. Morgan Chase (JPM), Goldman Sachs (GS) and Morgan Stanley (MS). Moody's cut Citigroup's long-term senior debt two notches, to Baa2 from A3, and said Citi's outlook was negative. The bank's short-term Prime-2 rating was affirmed. Citigroup's shares counter-intuitively moved sharply higher Friday morning, before backtracking to close higher by 0.6% on the day. So what gives then? Do the opinion's of Moody's (MCO) and Standard & Poor's (MHP) matter anymore anyway? Finally, what does this mean for C shareholders? We'll try to answer all that for you here, as C shares drop sharply lower Monday.
Specifically, Moody's said:
All of the banks affected by today's actions have significant exposure to the volatility and risk of outsized losses inherent to capital markets activities", says Moody's Global Banking Managing Director Greg Bauer. "However, they also engage in other, often market leading business activities that are central to Moody's assessment of their credit profiles. These activities can provide important 'shock absorbers' that mitigate the potential volatility of capital markets operations, but they also present unique risks and challenges.
Moody's put Citigroup into a grouping (Third Group) it considers higher risk than those it categorized within the "First" and "Second" groups of downgraded banks. With regard to Citigroup specifically, Moody's said:
The third group of firms includes Bank of America, Citigroup, Morgan Stanley, and Royal Bank of Scotland (RBS). The capital markets franchises of many of these firms have been affected by problems in risk management or have a history of high volatility, while their shock absorbers are in some cases thinner or less reliable than those of higher-rated peers. Most of the firms in this group have undertaken considerable changes to their risk management or business models, as required to limit the risks from their capital markets activities. Some are implementing business strategy changes intended to increase earnings from more stable activities. These transformations are ongoing and their success has yet to be tested. In addition, these firms may face remaining risks from run-off legacy or acquired portfolios, or from noteworthy exposure to the euro area debt crisis.
Bloomberg View, an editorial commentary I listened to on the company's business radio station in New York Monday morning, remarked that the rating agencies have become backward looking measures. The report went on to talk about the steps Wall Street and banks have taken to sure up their balance sheets and risk management over recent months, stating that investors are looking to the current situation, which is better than what the rating agency's report reflects (paraphrasing). Certainly, Moody's and S&P have been playing catch-up in a major way since the real estate bubble burst. Also, the initial reaction of the market seemed to say the agencies are irrelevant, as also covered by Bloomberg in this article.
However, maybe Moody's is right this time. The latest situation at J.P. Morgan Chase certainly supports that possibility. On Sunday evening, the Financial Times offered some interesting insight on the subject, which I believe illustrates one reason why the market may reconsider its initial disinterest in Moody's changes before too long. The report shows real changes in business activity because of the Moody's report, with Citigroup and the other institutions operating under Prime-2 short-term ratings suffering losses of business to the likes of The Toronto-Dominion Bank (TD) and PNC Financial Services Group (PNC). That hits the bottom line.
The risk to investors is not limited here either, because in many cases when more than one rating agency reduces the credit worthiness of firm, institutions must find new business partners in order to honor their charter's and promises to investors in their funds or investment instruments.
The shares of the banks in question are off sharply Monday, with Citigroup lower by a severe 4.9% at the hour of scribbling here. Perhaps, then, investors are already reconsidering their initial reaction to the Moody's report. The four banks within that "Third Group" were off between 3.5% and 5% Monday at 1:30 PM EDT, whereas the banks in the "First Group", HSBC (HBC), J.P. Morgan Chase and Royal Bank of Canada (RY) were off a lesser 1.4% to 2.8%. Questions about Europe are again driving stocks lower, and Moody's did not fail to mention these firms' "noteworthy" ties to the region's woes.
Valuation would not matter should event risk be realized by these firms, though it is limited if the stocks are already discounted for the risks. The banks' price-to-book ratios already bear some penalty for risk, though the ratios are not clearly delineated between Moody's groupings. Still, the four banks within that "Third Group" are certainly trading at the bottom of the P/B ladder, with Citigroup at a price-to-book of 0.45X. That is definitely cheaper than its long-term historical record, but in line with the post financial crisis era. Does that mean Citi and the others can't trade lower? The answer is no. Is the risk worth bearing now, considering the developments within global financial markets? I think the market is righter today than it was last week, so the answer is again no in my view. That said, these stocks, including Citi, may offer day traders willing to bear risk some trading opportunity due to volatility. As for the long-term investor, I would recommend avoiding the shares of Citigroup and the others within that third grouping for now.