Bank of America (NYSE: BAC) shares sank 4.3% Monday, as the SPDR S&P 500 (NYSE: SPY) fell 1.6%, reportedly on concerns about Europe. Spain formally asked for funds to bailout its banks, and hopes about the EU summit this week dimmed as Germany is seen not supporting common area bonds. BAC shares exaggerated the decline of the broader market for good reason, because of its heightened risk, which was highlighted just last week.
Moody's (NYSE: MCO) cut the debt ratings of 15 banks and securities firms late last week, including Bank of America . Moody's cut Bank of America's long-term senior unsecured debt to Baa2 from Baa1, outlook negative. The bank's short-term Prime-2 rating was affirmed. BofA's shares moved counter-intuitively higher last Friday despite the report, climbing 1.5%. Yet, the retrenchment Monday seems to show buyer's remorse, and I think for good reason.
Moody's Reported on BofA and Others:
"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 placed Bank of America 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 BofA specifically, Moody's said:
"The third group of firms includes Bank of America , Citigroup (NYSE: C), Morgan Stanley (NYSE: MS), and Royal Bank of Scotland (NYSE: 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 New York radio 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. 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 (NYSE: JPM) 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 Bank of America and the other institutions operating under Prime-2 short-term ratings suffering losses of business to the likes of The Toronto-Dominion Bank (NYSE: TD) and PNC Financial Services Group (NYSE: 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 lowers the credit worthiness of a 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 were off sharply Monday, with BAC lower by a severe 4.3% at the close of trading. Perhaps, then, investors are already reconsidering their initial reaction to the Moody's report. The four banks within that "Third Group" were each off sharply, with Morgan Stanley down 4.7%, Citigroup lower by 4.4% and Royal Bank of Scotland cut 3.4%. The "Second Group," based on slightly lower assessed risk, included Barclays (NYSE: BCS) down 4.3%, BNP Paribas SA (OTC: BNPQY.PK) lower by 5.8%, Credit Agricole SA (OTC: CRARY.PK) down 5.7%, Credit Suisse in the red by 3.8%, Deutsche Bank (NYSE: DB) down 4.9%, Goldman Sachs (NYSE: GS) lower by 2.6%, Societe Generale (OTC: SCGLY.PK) down 6.9% and UBS (NYSE: UBS) off 4.4%. The second group's European-based institutions did worse for obvious reasons. You can see the graduation of risk as we move to the day's performance of the "First Group", as defined by Moody's. HSBC (NYSE: HBC) was only lower by 1.3%, while J.P. Morgan Chase fell just 1.9% and Royal Bank of Canada (NYSE: RY) fell 2.3%. With European concern driving the market, Moody's mention that these firms carry "noteworthy" ties to the region's woes clearly weighed heavily.
Valuation should not matter if event risk is realized by BofA and the other higher risks, though it is limited if the stocks are already discounted for the risks noted. The banks' price-to-book ratios already bear some penalty for risk, though the ratios are not as clearly delineated between Moody's groupings as Monday's price movement was. Still, the four banks within that "Third Group" are certainly trading at the bottom of the P/B ladder, with Bank of America at a price-to-book of 0.4X. That is definitely cheaper than its long-term historical record, but in line with the post financial crisis era. Does that mean BofA 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 was righter Monday than it was last week, so the answer is again no in my view. That said, these stocks, including Bank of America, 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 Bank of America and the others within that third grouping for now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.