Why the credit downgrades will make banks riskier

June 22, 2012: 12:27 PM ET

The ratings changes might further consolidate Wall Street's riskiest business into the hands of JPMorgan and Goldman.

Fortune -- There's plenty of irony in the Moody's downgrade of big U.S. banks. But here's the biggest one: The lower ratings, which acknowledge that banks aren't as safe as we thought they were, might actually make the banks riskier.

In one sense, the downgrades will do something that regulations have yet to accomplish. They'll limit the banks' ability to gamble their own money. The banks will have to hold more of their cash as collateral, meaning they won't be able to give as much of it to London whales. It will also make it harder for banks to use the type of short-term financing that contributed to the bankruptcies of Lehman Brothers and MF Global.

MORE: Bond downgrades could hurt Wall Street more than some think

But in an increasingly important and enormous sector of the financial markets – derivatives -- the downgrades might actually make the banking sector more dangerous.

After the downgrades, there are two camps when it comes to the U.S.'s largest banks. It's JPMorgan Chase (JPM) and Goldman Sachs (GS), which now have A ratings, on the high ground, and Morgan Stanley (MS), Bank of America (BAC) and Citigroup (C), which now have a Baa rating, that are going to be forced to pitch their tents at base camp. (Wells Fargo is also in the higher group, but they aren't big in the derivatives business.)

Ratings don't matter much in lending. Banks get most of their money to lend from deposits, which are backed mostly by the FDIC and, as a result, Uncle Sam. So the credit downgrades are unlikely to make anyone switch their money from Bank of America or Citibank to Chase.

But in the world of derivatives, ratings matter a lot. Derivatives are a huge -- by some measures as large as $600 trillion -- and potentially risky business. It's the business that led AIG to bailout. In general, derivatives are bets that banks and investors place on interest-rates, commodities and bonds. And they mostly go unfunded, meaning the bulk of the money on the line doesn't exchange hands until after the bet is closed.

MORE: Risk is back on Wall Street!

Large banks don't typically post initial collateral when they trade derivatives with hedge funds, pension funds and other buy-side firms. They do have to post follow-on collateral when those trades fall in value and when they trade with other banks, and will have to post more after the downgrades. But initial collateral for those trades comes from the buy-side firms. And when the banks go out of business, it's the hedge funds', sovereign-wealth funds' and pension funds' money that is on the hook. As a result, all things being equal, hedge funds will trade with the highest rated firm.

A person in charge of clearing trades at one of the world's largest hedge funds said the ratings changes would defiantly affect where his firm and others trade. "Buy-side firms will look at the downgrades and see Morgan Stanley sliding toward Lehman," he said. "Why would I want that risk?"

MORE: Will the Fed's Twist get banks to lend?

What's more, because firms with higher credit ratings have to post less follow-on collateral, they can also offer better derivative pricing.

That means the new ratings split is likely to further migrate this potentially risky business, to the ratings high-ground -- namely at JPMorgan and Goldman -- making the potential losses even larger and more unmanageable, without a bailout, that is.

There is one hope. As part of the Dodd-Frank rules, regulators have been pushing for the bulk of derivative trades to be run through central clearing houses. Clearing levels the playing field among firms, because everyone, including the banks, have to post the same amount of collateral no matter what their credit rating is.

Wall Street has been fighting the rules, which are mostly written and could go in place as soon as the end of the year. But now that the credit downgrades put Morgan Stanley and others at a disadvantage, those firms might get behind the effort to centrally clear derivative trading. The result could be to disperse the business among more firms, spreading the risk.

But even if the clearing crowd and regulators win this round, that won't last for long. Wall Street is sure to come up with some other over-the-counter, highly structured investment that won't fall under the current definition of a derivative. It always does. The unregulated products are always the most profitable for the banks. And whatever that is, because of the credit ratings, it will mostly be traded by JPMorgan and Goldman. And when it eventually blows up, you know who will have to pay for it: you and I.

  • The Greek default trade

    The Greek time bomb hasn't been defused by any means, but for now it isn't ticking quite as loudly.

    In the glass half full of something nasty department, the price of insuring Greek bonds for a year has come down lately (see chart, right), according to data provider Markit.

    This suggests not that the situation in Greece is improving, mind you. The country is still buckling under a recession that's being deepened MORE

    - Jun 14, 2011 1:51 PM ET
  • Moody's downgrades Greece again

    The Greek comedy took another twist Wednesday.

    Moody's downgraded Greece again, putting 50-50 odds on a default thanks to the country's strapped finances and tortured European politics.

    The rating agency cut Greece's rating to Caa1, its third-lowest rating, and kept its outlook negative, meaning another downgrade could come soon. Moody's cited rising chances that the country won't stabilize its debt burden, which has been getting heavier as borrowings rise and the economy MORE

    - Jun 1, 2011 3:41 PM ET
  • U.S. debt: riskier than Bulgaria's?

    Think the debate about U.S. creditworthiness can't get any sillier? Guess again.

    A week after Standard & Poor's finally told us what we already knew, that the U.S. fiscal fiasco is in danger of spinning out of control, along comes Weiss Ratings of Jupiter, Fla., to reaffirm we can't max out our national credit cards forever without paying the price.

    Few would disagree on this point. But perhaps aiming to grab a MORE

    - Apr 28, 2011 2:32 PM ET
  • No downgrade for France

    Contrary to what you might have thought over the past week or two, every country in Europe isn't in danger of an imminent downgrade.

    So says Standard & Poor's, which affirmed France's triple-A rating Thursday. The rating agency cited French belt-tightening progress and a political environment that it says is "stable and oriented toward prudent economic policies."

    The rating agency said it expects the economy to grow slowly but surely in 2010 MORE

    - Dec 23, 2010 2:47 PM ET
  • S&P threatens Portugal downgrade

    Standard & Poor's tossed a bit of fuel on the euro zone financial blaze Tuesday by threatening to downgrade Portugal.

    S&P put its A-minus long-term debt rating on Portugal on CreditWatch with negative implications, saying a downgrade is possible in the next three months. The move comes as the weaker European economies, known collectively as the PIIGS for Portugal, Italy, Ireland, Greece and Spain, are under attack in the bond markets.

    Ireland MORE

    - Nov 30, 2010 4:56 PM ET
  • S&P downgrades Ireland

    The luck of the Irish took another hit Tuesday with Ireland's latest downgrade.

    Standard & Poor's cut Ireland's sovereign debt rating by a notch to double-A-minus, citing the massive cost of patching up the hemorrhaging Irish banking system.

    The news comes at a time when worries about Ireland's finances have loomed larger in financial markets. The cost of insuring against a default on Irish government debt has risen 25% over the past month, approaching MORE

    - Aug 24, 2010 5:43 PM ET
    Posted in: ,
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by VIP.