Michael Feroli at JPMorgan had an interesting note this morning (via ZH) on the Republican letter to Bernanke, pointing out that this sort of saber-rattling against easing might actually make it more likely as a way for the Fed to assert its independence.
Moody’s downgrade of BAC/WFC/C, on the other hand, may have the opposite effect, precisely because the government hasn’t yet been able to declare its independence from the ratings agencies. Moody’s cut the banks’ credit ratings because they think the government is less likely to bail them out if they run into trouble. And that downgrade itself may have the effect of making the government less likely to bail out the banks if they run into trouble.
Here’s what Moody’s said about the downgrade:
The downgrades result from a decrease in the probability that the US government would support the bank, if needed. Moody’s believes that the government is likely to continue to provide some level of support to systemically important financial institutions. However, it is also more likely now than during the financial crisis to allow a large bank to fail should it become financially troubled, as the risks of contagion become less acute.
“Fail” is kind of a vague word – you could argue that laying off 30,000 or so people, or getting sued by anyone who can find a lawyer, constitutes failure of a sort – and you could say the same thing even more forcefully about being sold to another bank for $2. But presumably what Moody’s means is “the government is more likely to allow a large bank to file for bankruptcy and not pay off its unsecured creditors at par.”
Is that true? Sure, why the hell not. But it’s an odd question for Moody’s. Lots of people criticized S&P for going out on a limb and hazarding political guesses when it downgraded the US for showing a lack of political spiine, and you could do the same here: Moody’s has no more reason than you or I to know what the government will do to BofA’s unsecured creditors if the bank can’t find enough money to pay off everyone suing them.
But Moody’s does have some say in the matter. Despite talk about removing ratings from regulations, they still matter, both formally and informally. Just for example, commercial paper rated P-2 (as BAC’s now is) is treated as a “second tier security” for money market funds, which means under Rule 2a-7 that it can’t make up more than 3% of fund assets. So a change in Moody’s rating can have a real, regulatorily required effect on demand for BAC paper from money market funds.
Does that matter? It doesn’t seem particularly likely to drive them into bankruptcy – BAC said in response to the downgrade that “to minimize any potential impact of this decision on our business, we have been managing our liquidity carefully and we have prefunded our planned borrowing needs for the year.” Though note BAC’s last 10-K, which disclosed $60 billion in outstanding CP:
If Bank of America Corporation’s or Bank of America, N.A.’s commercial paper or short-term credit ratings (which currently have the following ratings: P-1 by Moody’s, A-1 by S&P and F1+ by Fitch) were downgraded by one or more levels, the potential loss of short-term funding sources such as commercial paper or repurchase agreement financing and the effect on our incremental cost of funds would be material.
But does it matter to a likely government bailout, contingent on BofA actually running out of money? Well, if your model of bailouts holds that the government is more likely to bail out creditors who are, say, retail money market investors or nonfinancial corporations hoarding cash or other conservative money market investors, then yeah, it should. Here’s an oldie but goodie from the WSJ:
In bailing out AIG, the Federal Reserve appeared to be motivated in part by worries that Wall Street’s financial crisis could begin to spill over into seemingly safe investments held by small investors, such as money-market funds that invest in AIG debt.
More generally, bailouts operate in a realm of managing moral hazard, where the desire to help innocent bystanders conflicts with the desire to punish stupid creditors who didn’t monitor the bank that they invested in. Prime money market funds and investors who bought A2 rated term debt may seem at least incrementally more deserving of a bailout than schmucks who bought middling triple-B unsecured bonds. And in that sense Moody’s could help to cause the effect that they’re predicting.
Random aside: Moody’s rating action on BAC includes the following:
The ratings for BAC’s noncumulative preferred stock and the HITS issued by BAC Capital Trust XIII and BAC Capital Trust XIV, which do not incorporate any government support, were confirmed at Ba3 (hyb).
So the rating on BAC’s preferred stock is junk, unchanged, and never included any government support. Probably fair. But: if you were to bet on the probability that powerful people would protect holders of Bank of America preferred stock now, versus a month ago, when would you think it was more likely?