Surprise, Surprise, Surprise! Banks Downgraded

In my May 25th blog post I wrote:

"Are the U.S. financial institutions prepared for what is happening in Greece? The answer is, "It depends on which banks you're talking about."  The vast majority of the American banks have no exposure whatsoever to the Greek financial crisis with the exception of our very largest banks - Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley, Goldman Sachs and Wells Fargo.  These six banks have definite exposure to what's happening in Greece.  All reports say that their exposure to Greek insolvency is manageable.  If you want to believe what the banks are telling you then we have nothing to be concerned about.  Call me a cynic, call me a "glass half-empty type of guy, but I don't believe it."

Last Thursday, Moody's cut the credit ratings of 15 of the world's largest financial institutions including five out of the top six largest banks in the U.S. - Bank of America, Citigroup, J.P. Morgan Chase, Morgan Stanley and Goldman Sachs.  As Gomer Pyle would say, "Surprise, surprise, surprise!" 

Why were they downgraded?  Reasons given were:

• Marginal liquidity
• Exposure to the European debt and banking crisis
• Unspecified volatility and risk management problems in their capital markets activities

How will a lower credit rating affect these banks?

• It will make it more expensive for them to borrow money.
• It will make it more difficult to sell their commercial paper to money market funds.
• It will likely require them to increase their capital requirements.
• It will likely have an adverse affect on the value of their publicly traded stock.

Did Moody's consider all 15 banks equally in trouble?  No.  Moody's grouped the 15 institutions into three categories based on their relative credit-worthiness.

• The strongest group had solid capital buffers and "contained" exposure to the European crisis.  J.P. Morgan Chase falls into this category.
• The second group had varying risk factors, ranging from high dependence on capital markets operations to limited liquidity and exposure to Europe.  Goldman Sachs was in this category.
• The weakest group had experienced problems with volatility and risk management, and in some cases had weaker buffers than their peers in the industry.  Bank of America, Citigroup & Morgan Stanley were in this category.

Bank of America and Citigroup's credit rating are now rated two notches about junk status, while Morgan Stanley is three notches above. 

Are the credit agencies done downgrading the world's largest financial institutions?  Not even close.  Most of the European banks have been downgraded on several occasions over the past few years and I suspect that further downgrading of our largest banks will continue unless drastic improvement occurs over the next couple of years. 

It is hard for me to believe that one or more of these major U.S. banks will not falter and eventually collapse of its own bad decision making.  The real question is not if it will happen, but when, and more importantly whether those in authority at The Federal Reserve and U.S. Treasury Department have a comprehensive plan to contain the fallout when this occurs.  I suspect that they do have a plan and I suspect that they hope that they don't have to implement it.  That and $1.65 will get you a tall cup of coffee at Starbucks.   

Sources: Major banks downgraded by Moody's, @CNNMoneyInvest, by James O'Toole, June 21, 2002; A Sober New Reality in Credit Downgrades for Banks, DealBook, NYTimes edited by Andrew Ross Sorkin, June 22, 2012.

Another Questionable Decision by The Federal Reserve

The Federal Reserve last Thursday released a proposal that would implement a global agreement known as Basel III. This agreement is a regulatory standard that proposes minimum capital requirements and liquidity standards for all financial institutions worldwide.

I know what you’re thinking as I was thinking it too: I’m tired of reading another boring article on banking regulations. But I would encourage you not to delete this blog post before you get a “view from 35,000 feet” on how Basel III is going to impact the commercial real estate industry. It could have an enormous adverse impact on our industry if not implemented gradually.

From our perspective the most egregious new implementation being proposed by Basel III is assigning a higher risk weight to commercial real estate loans of 150%, up from a current risk weight of 100%. How does that affect the bank? The more risk, the more capital that’s required by financial institutions to have on hand as a buffer. So the more they lend on commercial real estate the higher their capital requirement. If they lend on other assets, home loans or businesses for example, they will not be required to hold as much in reserve.

So what do you think the banks are going to do when this new rule is fully implemented? Do you think they will lend more or less on commercial real estate? Of course, the tendency will be to lend less. And how do you think in real terms that will be done? I think there will be fewer banks lending on commercial real estate and those that do will find a plethora of ways to make it that much more difficult to get a loan approved and closed (as if we need more banking regulations to slow down the loan approval process).

This isn’t me just “crying wolf.” Fitch Ratings estimated last week that the world’s 29 largest banks will need to raise another $566 billion by the end of 2018 to meet these new international liquidity requirements against risk. Where is that going to come from?

I wonder why they consider commercial real estate so risky? The Great Recession was brought about by a housing bubble and lax underwriting standards for qualifying borrowers of home loans, not because of excesses in the commercial real estate industry. So why pick on us? Why make commercial real estate the scapegoat? The Federal Reserve needs to think this through and figure out what the ramifications are to our economy if this is fully implemented. Basel III ultimately means less lending on commercial real estate which means a slower economy which means fewer people being employed.

I’m all in favor of reforming the banking industry (remember I’m in favor of Dodd Frank) but increasing the risk weight for commercial real estate may be over the top. There’s got to be someone on The Federal Reserve Board of Governors who has enough common sense to understand this and has the courage of his convictions to push back. Don’t you think?

Sources: Basel III, Wikipedia; Fitch Ratings: World's Biggest Banks May Need To Raise $566 to Comply With New International Rules, Huffington Post, June 7, 2012; Fed ups capital buffer for commercial real estate, Market Watch, The Wall Street Journal, June 7, 2012; Federal Reserve unveils Basel III bank capital proposal, The Economic Times, June 8, 2012.