Investment banking can be a confusing subject for anyone, especially when it involves credit ratings and downgrades. Moody’s recent credit downgrading of 15 banks can seem like another bit of bad news for the economy but, while this may be true, it was a necessary step to accurately represent the current status of both domestic and foreign markets.
What is referred to as “Moody’s” by many people today is officially called Moody’s Investors Service. It was started in 1900 when John Moody published his first market assessment and quickly became recognized as a reliable and objective assessor of not only markets, but companies, stocks, and even fixed income securities. He created a rating system ranging from Aaa down to C to measure the risk of an investment. Essentially Moody’s tries to classify the amount of risk of a security or company and the higher rating Moody’ gives the better. The boundary between Baa3 and Ba1 is known as the line between investment grade investments and speculative grade investments. The worst rating an entity has, the more likely debt from that company is going to go unpaid. Riskier debt means that the company has to pay more through interest to compensate for this higher level of risk. This is the same idea as personal credit ratings and how those with lower credit scores have to pay higher interest on things like mortgages and car loans. Overall Moody’s ratings have come to be known as an effective and fairly objective way to assess the risk of a possible investment.
This past Thursday Moody’s officially announced that it would be lowering the credit ratings on many of the world’s largest banks. This list of 15 banks included Bank of America, Barclays, Deutsche Bank, Credit Suisse, JP Morgan Chase, and Goldman Sachs among others. These announcements did not come as a surprise as Moody’s alerted the banks of the possibility of a downgrade in late February of this year. Overall the reasoning from the agency is a concern over their exposure to volatility in the markets. According to Moody’s these banks have “problems in risk management or have a history of high volatility”, and therefore needed to have their credit ratings amended. While it is hard to not be exposed to volatility somewhat in present markets, these banks in particular were exposed to more than what Moody’s deemed reasonable in present conditions. JP Morgan for example recently had to come before Congress to explain why they suffered around a $2 billion loss related to a single hedging strategy. International banks, on the other hand, typically have a much higher exposure to the European debt crisis. These international banks, such as Deutsche Bank, are more closely tied to the fate of other European banks and countries making their holdings riskier than a typical bank. All of these factors add up to substantial risk in Moody’s eyes, which needed to be represented in lower credit ratings for these banks.
Although it is understandable why Moody’s took the measures they did to more accurately reflect the perceived risk of these banks, it is a little more unclear the exact effects on the banks themselves. The main problem for the banks is this will increase the cost of lending. Much of the business that banks do day-to-day is by lending money, equities, and bonds to each other as outright loans and also as collateral. These investment banks have millions if not billions of dollars in lent assets in markets, as well as millions of dollars from other banks as well. A lower rating essentially means that these leant assets are now “riskier”. This is because a lower credit rating means that the bank is more likely to be unable to repay those assets. Therefore it also means that not only will future borrowing be more costly for banks, but they must also reassess the risk of all of the assets currently lent out. Not only is this a huge undertaking for the banks to do, but also a higher cost of lending should have negative impacts for Wall Street and the economy. Higher cost of lending means investment banks, which are the engines of the economy, will be less likely to lend money.
Many people were fearful that such a wide-sweeping move across so many important financial institutions would have far reaching consequences passed onto the consumers. This fear is logical as whenever it becomes more expensive for a company to do business there is a chance they will pass some of that cost on to their customers. Modern financial banking is essentially tied to all sectors of industry and therefore indirectly tied to consumers. More directly consumers are affected by decisions of these large financial institutions primarily through their mortgages. In this case is seems unlikely that too many consumers will be significantly effected by this situation. Moody did a good job allowing the official downgrades to not be a complete surprise by going to the banks directly this past February. Shocks in the financial world are what bring about drastic consequences. Since everyone foresaw this coming and really understands why it is appropriate it is unlikely that the downgrading of these major financial institutions will have a significant effect on consumers.
Sources:
Tulsa World News
Moody’s.com
Financially Stephen grew up in a family that preached saving and living below your means. That, in part, translated to his interest in Economics, especially how economics can affect individuals’ financial lives. Through his financial markets class in the fall of 2011, he furthered this interest by analyzing macroeconomic events. Stephen believes that finance, personal finance in particular, is a subject severely left out when it comes to public schooling in this country, and it is a problem that has manifested itself and contributed to many of the problems seen today. He also believes that education is the key to improvement and hopes that through his writings he will be able help people learn about finance, macroeconomics, and how to be financially savvy for the future.
In his free time Stephen enjoys playing and watching sports, wakeboarding, sailing, and country music. At UNC he has participated in Strive for College, UNC Dance Marathon, and UNC Relay for Life.
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