For all the speculation over how far Moody's Investors Service will lower the credit ratings of the world's largest banks, debt traders are already treating the firms like they're graded lower than the biggest potential cuts.
Bonds issued by Morgan Stanley and Credit Agricole SA have dropped to prices implying junk ratings, while credit-default swaps on Bank of America Corp., Goldman Sachs Group Inc. and BNP Paribas SA are trading as if the lenders were speculative-grade issuers, according to a separate Moody's unit that analyzes market data. Even the harshest downgrades in the ratings firm's review would leave those banks investment grade.
Investors are fleeing global financial institutions as Europe's escalating fiscal crisis threatens to poison the balance sheets of the region's lenders and spread to trading partners globally. Moody's, which has been reducing ratings for banks from Australia to Austria, has said that 15 banks with a combined $28.2 trillion of assets may be the next group it cuts as part of a review that will conclude this month.
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"The financial companies run with much more leverage than similarly rated non-financial companies, and their spreads reflect that," said Richard Familetti, senior portfolio manager at New York-based Ryan Labs Inc., which manages $4.5 billion. Investors see bank debt to be as risky as BBB rated bonds of industrial companies, he said in a telephone interview.
James Gorman, Morgan Stanley's chief executive officer, has been trying to convince Moody's that the bank doesn't deserve the potential three-level downgrade it's facing after boosting its capital, selling businesses and adding liquidity. Goldman Sachs Chief Financial Officer David Viniar said in April that the firm, led by CEO Lloyd Blankfein since 2006, shouldn't be cut.
Morgan Stanley, rated A2 by Moody's, may be cut as low as Baa2, the rankings firm said. The prices of the New York-based bank's bonds imply a rating of Ba1, two levels below that grade, according to Moody's capital markets research group. The average yield on Morgan Stanley debt climbed to 5.8 percent on June 7, from 4.7 percent on February 14, before Moody's announced its review, Bank of America Merrill Lynch index data show.
Bonds of French lender Credit Agricole, which faces a potential two-level downgrade to A2, trade at prices that suggest a Ba3 rating, nine steps below its current grade, according to the Moody's research group. Its average euro-denominated debt yields were 5.7 percent as of June 7, the index data show.
Global Spreads
Elsewhere in credit markets, Internet connectivity provider Zayo Group LLC is offering $1.25 billion of bonds to finance its acquisition of AboveNet Inc. in the largest high-yield offering in almost a month. BAA Ltd., the owner of London's Heathrow Airport, obtained 2.75 billion pounds ($4.3 billion) of loans to refinance debt maturing next year. A gauge of U.S. corporate credit risk rose the most since June 1.
The Markit CDX Investment-Grade index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, rose 2.1 basis points to a mid-price of 122.7 basis points as of 11:12 a.m. in New York, according to prices compiled by Bloomberg. The index reversed an earlier decline as optimism over Spain's 100 billion-euro bank rescue faded and Italian 10-year government bond yields rose for a fourth day.
In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings rose 0.8 to 177.1 after earlier dropping by as much as 8.8. Both indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a swap protecting $10 million of debt.
Zayo, whose fiber network will comprise 68,000 miles across the U.S. and Europe, is planning to issue $750 million of senior secured notes due January 2020 and $500 million of senior debt due July 2020, according to a person familiar with the transaction. The securities are expected to be rated B1 and Caa1 respectively by Moody's Investors Service.
Proceeds will be used to finance the acquisition of AboveNet, refinance existing Zayo and AboveNet debt, and pay related fees and expenses, said the person, who asked not to be identified because the terms are private.
Awaiting Moody's
BAA increased the size of its facility after lenders oversubscribed the deal. The financing includes a five-year, 2 billion-pound revolving credit, split among a 1.5 billion class A portion, a 400 million-pound class B piece and a 100 million-pound working capital facility, according to a statement from London-based BAA. The class A loan plays interest of 150 basis points more than the London interbank offered rate and the class B pays 225 basis points more than Libor, the company said.
Moody's announced the bank-rating review in February, saying firms that earn money in capital markets are challenged by "fragile funding conditions, wider credit spreads, increased regulatory burdens and more difficult operating conditions."
Bank profits have dropped as trading and deal volume fell amid concerns that the European debt crisis would cause a worldwide slowdown and investment banks cut assets to prepare for tighter capital rules. Investment banking and trading revenue at the 10 largest global firms has dropped 19 percent each of the past two years, according to data from industry analytics firm Coalition Ltd., leading banks to announce more than 200,000 job cuts last year.
The ratings company has delayed its decisions, saying it will complete the review by the end of June after scheduling it for mid-May. A timetable published in April indicated that the investment-bank downgrades would likely follow those of Finland's lenders, which came on May 30. Abbas Qasim, a spokesman for the firm, said that order wasn't definite and declined to say when Moody's will take action.
"Everybody is anticipating these downgrades," said Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP, which oversees $35 billion. "The fear here is that the downgrades are more negative than even the market anticipates."
Mary Claire Delaney, a spokeswoman for Morgan Stanley, declined to comment, as did Jerry Dubrowski, a spokesman for Bank of America, and Tiffany Galvin, a spokeswoman for Goldman Sachs. Messages left with Cesaltine Gregorio of BNP Paribas and a press relations mailbox at Credit Agricole weren't returned.
Markets Diverge
"We think that if you look at every single credit metric there is for Goldman Sachs and, frankly, for many of our competitors, none of the actions they've talked about are warranted," Goldman Sachs's Viniar said when asked about the Moody's ratings review on an April 17 conference call to discuss earnings.
"We're saying to them we're actually in much, much better shape than perhaps was understood by the marketplace and the ratings agencies," Gorman said in a CNBC interview on May 31.
Market-implied ratings for the biggest U.S. banks began diverging from their actual grades in 2006 and 2007 as concerns started emerging over a housing-market slowdown that fueled the biggest financial crisis since the Great Depression and led to the 2008 emergency sales of Bear Stearns Cos. and Merrill Lynch & Co. and the bankruptcy filing of Lehman Brothers Holdings Inc.
Even after record gains in investment-grade corporate bonds globally the past three years, investor appetite for bank debt hasn't recovered as the U.S.-led crisis shifted to Europe's debt-hobbled governments.
The extra premium that investors demand to own bank debt globally instead of the debentures of industrial companies has averaged 103 basis points in the more than three years since reaching a record 282 basis points in March 2009, Bank of America Merrill Lynch index data show. The gap stood at 114 basis points on June 8.
From 2000 to 2007, bank bond spreads averaged 52 basis points less than industrial debt, the index data show.
Investors have been losing confidence in banks' ability to profit as the global economy again weakens and regulation increases, Tony Smith, a senior director at the Moody's unit that calculates implied ratings, wrote in a report on June 7.
The average cost to protect against losses on the debt of the six-biggest U.S. banks has jumped 86 basis points from this year's low in March to 257 basis points, according to prices compiled by Bloomberg and data provider CMA. The average, which soared to a record 453 in October 2008, the month after Lehman Brothers filed for bankruptcy, reached 360 in November.
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Credit-default swaps on Bank of America, Goldman Sachs and BNP Paribas imply those banks should be rated Ba1, the top level of junk. Bank of America faces a downgrade to Baa2, Goldman Sachs could be cut two levels to A3 and BNP faces a two-step drop to A2.
Moody's analysts derive implied ratings from prices on bonds and credit-default swaps, gauging market values for a particular company against the broader market.
Part of the discrepancy may be accounted for by traders using the contracts to bet on the health of the economy, rather than on the riskiness of the banks, according to Randy Woodbury, a portfolio manager and trader at Des Moines, Iowa-based Principal Global Investors, which manages about $258 billion in assets. Investors are wary of brokerages that can't draw heavily on deposits and are more exposed to global threats, he said.
"The market is trying to become comfortable with the fact that this part of the industry is more of a BBB type than the AA it used to be," Woodbury said. "Investors are struggling to figure out what is the appropriate risk they want to be compensated for."
Bloomberg News
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