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Bank Debt Downgrades: Surf's Up

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The flow of bank debt downgrades has begun and while it feels like a trickle, investors in both bank debt and equity would be wise to watch this space.

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The following is the latest missive from Minyan Peter, author of such recent popular articles as Bank Earnings Post Mortem and A Closer Look At Mastercard's Earnings.


As we continue our downward trek through the credit cycle, I can't emphasize enough the importance of watching both capital adequacy and liquidity issues for banks. History shows that while financial losses start the snowball rolling downhill, it is liquidity (or rather the lack thereof) that ultimately does a financial institution in.

In looking at press headlines for the past week, it appears to me that the focus has been centered entirely on capital related issues – whose charge off was bigger and into what new loan category has the credit contagion spread. While admittedly, the numbers are large and growing, the news last week was largely backward rather than forward looking. It feels to me like the press missed the bigger news this week, which was the beginning stream of bank debt downgrades.

Of all segments of the economic marketplace, financial institutions are the most dependent on debt ratings. And like it or not, a significant portion of a bank's liability structure is "puttable" or easily redeemed.

High debt ratings allow banks to attract deposits from local municipalities and state governments. Bank funding also benefits from things like "escrow accounts" and other fiduciary deposits that may be put into bank deposits so long as the bank meets certain minimum debt rating requirements.

When a bank's debt ratings fall, however, substantially all these deposits must be moved quickly. The affected bank is then left in the position of having to replace heretofore stable and relatively low cost funding with more expensive and likely more volatile sources. Or alternatively, the bank must sell assets to raise cash, often at a loss. As you can see, however, in both scenarios, the bank's earnings/capital position is worse off. It is for this reason, that in a deteriorating economic environment, large "one-time charges" (like the ones we have just witnessed) quickly lead into serial bank debt downgrades.

This past week, with the impact of 3Q charges now evaluated by the rating agencies, the flow of bank debt downgrades has begun. Right now it feels like a trickle. But investors in both bank debt and equity would be wise to watch this space. Surf's up.


Minyan Peter has a position in SKF.
No positions in stocks mentioned.
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