BankWatch: Big Banks Face Financial Doomsday in 2012

The cost of borrowing funds for the largest American banks is going to skyrocket in the coming years -- and that's just the beginning of their troubles.

A confluence of factors are coming to a head: First, the credit ratings of large Wall Street banks like Goldman Sachs (GS), Morgan Stanley (MS), J.P. Morgan Chase (JPM) and Citigroup (C) are all under siege due to aspects of the financial reform bill, which was passed by the Senate last week. Second, that bill will restrict their lucrative derivatives and trading businesses, which is sure to put a crimp on their earnings. Finally, the vast amounts of government-backed cheap capital that these banks raised in the financial markets in 2009, will all have to be refinanced in 2012 at interest rates that could be as much as five times higher than those they got last year.

"Goldman Sachs alone has something like $21 billion of debt due then," says Tim Backshall, chief strategist with Credit Derivatives Research. "The average yield on those is less then 1%, or 77 basis points, and will likely go up to as much as 4% and 5%."

In fact, Goldman's massive debt pales by comparison to the amounts raised by others last year under the government-backed programs: Citigroup raised $64 billion, Bank of America (BAC) $44 billion, J.P. Morgan Chase $39 billion, and Morgan Stanley (MS) $25 billion. And most of this debt is due 2012.

With the higher regulatory capital requirements, those banks will likely have no option but to refinance, even if they have to cough up a hefty premium to do so. It certainly won't be pretty, because it will lead to a flood of bank debt in the capital markets, and that debt will be issued by banks that, by then, are likely to have lower credit ratings.

Uncle Sam Won't Catch Them If They Fall

Ratings today for the largest U.S. banks are propped up by the assumption that the government will support them: The financial regulatory reform bill will probably remove that assumption.

"The Dodd bill contains provisions that, if passed into law, could weaken our assumptions regarding the probability that the U.S. government would support the largest, most systemically important financial institutions," says Robert Young, managing director for Moody's North American Bank Ratings.

Currently, 17 of the 70 banks that Moody's rates, get a "lift" from the assumption of government support. In some cases, the ratings receive a huge boost from this assumption. For instance, Bank of America's Aa 3 rating includes a five-notch lift, while Citi and Wells Fargo gets a four-notch lift from the implication of government support.

Standard & Poor's, too, says that these factors will affect credit ratings, and points to other portions of the bill that will likely lead to reduced earnings at banks. An amendment popularly known as the Volcker Rule, which would restrict proprietary trading by banks and large non-banks, and prevent them from investing in hedge funds, will also lead to reduced earnings.

"We estimate that this provision could hurt the profitability of large institutions with significant revenues from derivative activities," S&P said in a report, which noted that the Volcker Rule will likely have the most impact on Goldman Sachs, which relies heavily on trading to boost earnings.

All these factors are casting a huge cloud on the banking sector. The Financial Select SPDR (XLF), an exchange-traded fund that reflects the performance of large banks, has declined 14% just in the last month and the volatility is likely to continue until all the wrinkles in the financial reform bill are ironed out.