Monday, March 29, 2010

US banks downgrades to Neutral from Overweight at JP Morgan- $BAC $GS $MS $WFC $XLF

1) the provisions of financial reform legislation and its chance of implementation, and 2) potential downgrades of large banks by the rating agencies if financial reform is enacted. First, the Dodd bill is currently under debate in the Senate, and the final regulations are not yet clear. This bill goes further than the bill already passed by the House in some respects: It requires both central clearing and exchange trading for OTC derivatives, while the House bill requires only central clearing. Both bills set up procedures for systemically important financial companies to be liquidated in a way that attempts to shield the broader financial system. The House bill requires that both creditors and equity holders take losses in such liquidation, while the Dodd bill states that there is a strong presumption of such losses for credit and equity holders. The bills both limit, to some extent, the ability of the government to bail out firms. The Dodd bill will work its way through the Senate and, if passed, be reconciled with the House bill, followed by votes in both chambers on a reconciled bill. Throughout this process there will be revisions and compromises, so the provisions of the final bill remain uncertain. Passage of any bill requires that Republicans in the Senate do not attempt to filibuster—a tactic perhaps less likely after their defeat in the healthcare debate.

The uncertainty over the bill and rating agency actions JP Morgan is advising their clients to have a Neutral position in US banks, rather than an Overweight position, as the legislature process plays itself out. JPM also sees small possibility that there is a multi-notch downgrade of the banks, but if this was to occur the negative impact on bank spreads would be a game changer in my own opinion. The most probable scenario is that there will downgrades and returns to Neutral outlooks by the rating agencies.

For creditors, evaluating the financial reform bill now raises two questions—what will the bill (if enacted) say and mean for bank profitability and credit risk, and what, if anything, will the rating agencies do with their ratings on the large banks post passage? Banks have outperformed recently, and this uncertainty will not be beneficial in the near term. On the other hand, large banks will likely report strong 1Q earnings in just a few weeks. This will likely highlight their improving credit trends and strong capital positions. Thus week by week it is unclear which headline will drive bank spreads as there is potential for both positive and negative news. Either way, volatility in bank credit will probably increase as these developments play out.

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