Credit rating cliff risk creeps to American banks

It’s been a lurking concern since early this year.
But late Tuesday credit rating cliff risk came to Bank of America, Wells Fargo and Citi care of Moody’s — thanks to the combustible dynamic between the new Dodd-Frank Act and the ratings agencies.
From the Moody’s statement:
Moody’s Affirms BofA, Citi, Wells Fargo; negative outlook on supported ratings
Unsupported ratings unaffected
New York, July 27, 2010 — Moody’s Investors Service today affirmed the long-term and short-term ratings of Bank of America (BAC), Citigroup (Citi), and Wells Fargo (WFC) while at the same time changing the outlook to negative from stable on their ratings that currently receive ratings uplift as a result of Moody’s assumption of systemic support (including their senior debt and deposit ratings). The outlook change is prompted by the recent passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) — a law that, over time, is expected to result in lower levels of government support for U.S. banks.
None of these banks’ unsupported ratings, such as their bank financial strength ratings (BFSR), were affected by this outlook change. The rating outlook on Bank of America’s and Citigroup’s unsupported BFSR is stable, while the rating outlook on Wells Fargo’s BFSR is positive.
In a separate action, Moody’s today also placed the supported ratings of 10 U.S. regional banks under review for possible downgrade (See press release dated July 27, 2010 “Moody’s reviews U.S. regional banks’ supported ratings.”).
The worry is that under new 2a7 rules, money market funds are pretty much limited to investing in A1-rated paper. At the same time, the Dodd-Frank Act rather explicitly seeks to eliminate government support for banks, which means rating agencies can no longer factor that ‘uplift’ into ratings.
Combine the two and you get a possible strain on banks’ funding.
Back to Moody’s:
“Since early 2009, Bank of America, Citigroup, and Wells Fargo’s ratings have benefited from an unusual amount of support,” said Sean Jones, Moody’s Team Leader for North American Bank Ratings. This support has resulted in debt and deposit ratings that range from three to five notches higher than that indicated by the banks’ unsupported, intrinsic financial strength. “The intent of Dodd-Frank is clearly to eliminate government — i.e. taxpayer — support to creditors,” said Mr. Jones. To achieve this, the law attempts to strengthen the ability of regulators to resolve complex financial institutions, while at the same time strengthening the supervision and regulation of such institutions to reduce the likelihood that they will need to be resolved in the future. (See Moody’s report “Credit Implications of the Dodd-Frank Wall Street Reform and Consumer Protection Act on U.S. Banks” for more on the rating agency’s views on the Act).
Over the near-term, as a practical matter, Moody’s thinks that regulators will continue to face significant obstacles when trying to resolve complex, interconnected, global firms without risking a systemically threatening contraction in credit. Therefore, we continue to believe the current ratings on these three banks are still appropriate.
However, over the next 12 to 24 months, as the new law is implemented, rules and regulations are written, and if economic conditions stabilize, we expect that our support assumptions for systemically important banks will likely revert to pre-crisis, or even lower, levels — though we do not anticipate that we would completely eliminate support from these firms’ senior debt and deposit ratings. If BAC’s, Citi’s, WFC’s, or some other systemically important banks’ unsupported bank financial strength ratings remain unchanged over this time period, then a reduction in our government support assumptions could lead to downgrades of their supported debt and deposit ratings.