Last Thursday, November 14, 2013, there was an important news item that hit my radar.
The credit rating agency Moody’s has cut its ratings of four major U.S. banks. The New York Times reports:
In its report Thursday, Moody’s lowered by one notch the holding company ratings for Morgan Stanley, Goldman Sachs, JPMorgan and Bank of New York Mellon […] reflecting a belief that the institutions would not receive the same level of government support in another financial meltdown.
Moody’s had originally warned of a possible downgrade on August 22 of this year. While some people may have ignored or dismissed it, it is now clear that this was not an empty warning.
Moody’s downgraded the credit ratings of four major U.S. banks on November 14, 2013.
So What Does the Rating Downgrade Actually Mean?
First, it helps to understand that credit ratings are designed to mislead American consumers. Most of us have grown up in public schools where a grade of A is excellent, B is good, C is average, etc.
In the banking world, they use the same letters, but they mean very different things.
For example, Morgan Stanley’s long-term senior unsecured debt was downgraded from Baa1 to Baa2, and its subordinated debt was downgraded from Baa2 to Baa3.
Just based on the letters involved in the rating, you might be inclined to think Morgan Stanley is doing okay, but you’d be wrong. Morgan Stanley’s credit rating is just one level above junk status now. Here’s what that means in terms of default risk:
One study by a rating service (Moody’s) claimed that over a “5-year time horizon” bonds it gave its highest rating (Aaa) to had a “cumulative default rate” of just 0.18%, the next highest (Aa2) 0.28%, the next (Baa2) 2.11%, 8.82% for the next (Ba2), and 31.24% for the lowest it studied (B2).
Did you catch that? The cumulative default rate spikes geometrically with each rating drop. And Morgan Stanley’s current rating means the actual default rate is somewhere between 2-8%.
Is Moody’s Hinting at Another Financial Meltdown?
Okay, so the banks are still on uneven footing, and Moody’s has really just confirmed what many of us have privately suspected.
What I find most interesting is what’s hidden between the lines. When Moody’s says the banks “would not receive the same level of government support in another financial meltdown,” what are they really saying?
On the surface, Moody’s is saying these banks are not financially stable enough to survive the kind of economic distress we experienced in 2008/2009. Without government bail-outs, Moody’s expects these banks to default or fail.
But below the surface it seems Moody’s is factoring “another financial meltdown” into their risk model. In other words, they seem to expect it.
I don’t know about you, but I’ve been factoring another financial meltdown into my planning ever since the market began to rebound in 2009. Until the problems that led to the first crisis are resolved, there is little hope for financial stability.