Moody’s is reviewing 17 global banks for downgrades that may come as early as June. The news is starting to fill with stories on how much extra collateral banks will have to pony up if they are downgraded and what could happen to funding sources. It’s not pretty.
A two-level downgrade of long-term senior debt ratings at B of A will, according to the bank, require them to post about $5.1 billion of collateral tied to derivatives contracts and other trading agreements. If trading counterparties decide they want to close out contracts (which presumably some may have the right to do after a two-level downgrade) an additional $1.1 billion of would be required. Bank of America in their March 31, 2012 10-Q filing said, “If the short-term credit ratings of our parent company, bank or broker/dealer subsidiaries were downgraded by one or more levels, the potential loss of access to short-term funding sources such as repo financing, and the effect on our incremental cost of funds could be material.”
Citibank disclosed in a regulatory filing that a two-notch downgrade of its bonds by rating firms could mean needing about $4.7 billion in additional collateral. Citigroup’s March 31, 2012 10-Q said, “…Citi estimates that a two-notch downgrade of Citigroup and Citibank, N.A., across all three major rating agencies, could result in aggregate cash obligations and collateral requirements of $4.7 billion. Of this amount, approximately $1.1 billion could result from a potential two-notch downgrade by Moody‘s only of both Citigroup and Citibank, N.A….” Citi also wrote in their 10-Q that a cut in their short term rating might impact their $25.3 billion in liquidity commitments to asset-backed CP conduits – a number which included $10.5 of commitments to unconsolidated conduits.
In November 2011 when S&P downgraded Citi, they said the impact was muted. From the March 31, 2012 Citigroup 10-Q, “…The above mentioned rating changes did not have a material impact on Citi‘s funding profile. Furthermore, forecasts of potential funding loss under various stress scenarios including the above mentioned rating downgrades, did not occur…” When the Moody’s shoe drops, will the market response be the same?
Morgan Stanley, facing up to a 3-notch downgrade, may have to provide $7.2 billion in additional collateral or termination payments, and another $2.4 billion in collateral requirements for exchanges and clearing organizations.
It will be interesting to see how all this will add up. Cumulatively, this could be a decent amount of additional collateral needed. The missing link is what happens with the big non-US banks. We also hear many CSAs with sovereigns and supra-nationals have collateral requirements which kick in upon downgrade below investment grade. Hopefully we won’t get there.
The other side of a downgrade is access to funding. B of A gets right to the point, noting that their access to repo might be damaged. Some banks fund more illiquid / funky assets via repo conduits. These conduits rely on the rating of the cash borrower and pretty much ignore the collateral. There is cliff & wrong-way risk associated with using these conduits. If the credit rating doesn’t pass muster, then access is cut off. That happens right when funding gets tight.
The last time there was a funding shock, the problem turned systemic and Bear and Lehman evaporated. The Fed stabilized the system by pumping in liquidity through (among other programs) the Primary Dealer Credit Facility (PDCF). Perhaps it is time for the Fed to dust off the PDCF manual?
Links to some articles on the downgrades and collateral requirements are here, here, and here.