Moody's has changed its outlook on the U.S. banking system to stable from negative, where it had been since 2008. The outlook expresses the rating agency's expectation of how bank creditworthiness will evolve in this system over the next 12-18 months. The agency cited "continued improvement in the operating environment and, more importantly, reduced downside risk to the banks in the event the economy falters" as the driving factors in its outlook change.
The agency highlighted strong capital and liquidity ratios as two key recent improvements, while noting that profitability continued to be under pressure from the low interest rate environment. Moody's noted that "interest rates are the single most important factor driving US banks' performance in the next 12-18 months. Low rates help to promote private-sector employment growth that more than offsets government job losses; low interest rates also have supported the recent improvements in the banks' asset quality metrics, with net charge-offs now approaching pre-crisis levels”.
However, such low interest rates also harm banks earnings. In the short term, low rates reduce a key source of profitability - banks' net interest margins. In addition, low rates encourage looser loan underwriting standards as banks seek out higher return, and consequently higher risk assets.
Bank holding companies (HoldCo)
Moody's stated that the sector outlook change is distinct from its negative outlook on the eight systemically-important U.S. banks, which is a result of the FDIC's Orderly Liquidation Authority (OLA) framework. The agency stated that the "disparity in outlooks between bank and holding company is a result of the credit implications of regulators eventually employing the favoured "single entry receivership" model for bank resolution. This is because single entry receivership aims to use the resources of the bank holding company – at the expense of its shareholders and creditors – to recapitalise a systemically-important bank, so that it can operate without being placed into resolution or receivership”.
Although not stated by Moody's, moving the U.S. banking system to stable could be a pre-cursor move to consider the possibility of upgrading the stand-alone ratings of some U.S. banks, particularly systemically-important banks which currently are facing ratings pressure at the HoldCo level due to the potential removal of sovereign support from the OLA framework, as noted above.
The stand-alone ratings for Citigroup and Bank of America at Ba1 for example are arguably too pessimistic particularly given their vastly improved balance sheets (albeit acknowledging that both companies face business model and earnings challenges in the current environment). Indeed it is likely the that the balance sheet improvement has been the key driver of credit spread contraction over the past twelve months for the U.S. banking sector which generated a total return of 15% in 2012. Given Moody's is likely to take one or both notches of government support away from the HoldCo level as a result of the OLA framework, the sector outlook revision could make it more likely that Moody's can upgrade the stand-alone ratings as a partial offset.
Moody's also noted that bank securities portfolios continue to grow, without enhancing franchise value and stated that it would "be increasingly concerned if banks took on higher-duration securities”. We agree that given the long period of historically low interest rates, and the erosion of yields on banks' balance sheets, there is a tendency for banks to begin to "reach for yield" by extending out on the duration or credit curve to securities that will decline in value when interest rates rise.
Given these elements, we prefer broker/dealers Goldman Sachs and Morgan Stanley as well as JPMorgan and Citigroup as compared to Wells Fargo and the more retail focused banks that appear more fully valued and more vulnerable to interest rate rises.