Will Bank Profits Get Clipped From Credit Rating Downgrades?

Profits at some of the nation's leading regional banks could suffer as the result of a potential credit rating downgrades stemming from the adoption of the Dodd-Frank financial regulation overhaul legislation.

Moody's Investors Service (MCO) has disclosed that it's reviewing 10 large regional banks for possible downgrades because it believes "the potential for government support for these banks will be reduced" following adoption of the Dodd-Frank legislation, which was signed into law by President Obama on July 21.

Moody's also said it was changing its credit outlook from stable to negative for Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC), also because of Dodd-Frank, though it said it was affirming both the short-term and long-term ratings of those banks.

The ratings agency said it had previously taken into consideration the government's statements that it would provide extraordinary support for regional banks when it issued its ratings for those firms in 2009. "Now that the U.S. banking system has moved beyond the depths of the financial crisis, the probability of government support for these banks could be lower, in Moody's view," it said in a release.

Still "Too Big to Fail"?

The 10 banks under review are subsidiaries of BB&T (BBT), Capital One Financial (COF), Fifth Third Bancorp (FITB), KeyCorp (KEY), PNC Financial Services (PNC), Popular (BPOP), Regions Financial (RF), SunTrust Banks (STI), U.S. Bancorp (USB) and Zions Bancorp (ZION). The U.S. government has a stake in six of the banks because of capital it injected at the height of the financial crisis under the TARP program, which those banks have not yet paid back.

Brian Kelly, president of Kanundrum Capital in Darien, Conn., says he thinks it's likely that the ratings agencies will downgrade those regional banks because the main point of the Dodd-Frank legislation was to remove taxpayer support for too-big-to-fail financial institutions. "There's a lot of unintended consequences coming down the line from Dodd-Frank," Kelly says.

Albert Savastano, banking analyst at Macquarie Capital (USA), notes that if Moody's does downgrade the regional banks, "it could cost them more to borrow." Borrowers with lower credit ratings generally have to pay more for loans. Higher credit costs would be an "incremental negative" for profits, Savastano says, but the banks might have other avenues to boost earnings.

But Savastano says he doesn't agree with the underlying Moody's analysis because there's nothing in the Dodd-Frank bill that leads him to believe the government will really end its support for those institutions. "When push comes to shove, when one of these too-big-to-fail banks is going to fail, do you really think they are going to wind it down?" he asks. "I don't think so."

Bullish View on International Banks

Kelly believes profits at the regional banks could suffer for a number of reasons. If a ratings downgrade causes credit costs to rise, at this point, the banks might have a hard time trying to pass those costs on to customers.

"We saw in all the banks' earnings reports over the last week that there's not much demand for credit," Kelly says. "If there's no demand, you can't really raise your price to lend. If the banks' costs of borrowing go up, obviously their margins get squeezed."

Kelly added that he thinks the regionals are suffering because small business is hurting at the moment. While U.S. economic indicators are turning downward, companies like Caterpillar (CAT) and IBM (IBM) are doing fairly well because of the strength of their overseas business. That suggests to him that U.S. weakness is primarily due to smaller businesses that don't have access to overseas markets.

For the same reason he's more bullish on the big money-center banks like Bank of America and Citi because they have exposure to Asia and other developing markets that are doing reasonably well.

Savastano disagrees, however, saying that the big banks may suffer more because that's where the bulk of derivatives trading and hedge fund and private-equity investing take place. Both of those activities have been curbed by the financial reform law, but the full impact of the law on earnings won't be known until regulators draft the rules under which it will be implemented.