Another Casualty of U.S. Downgrade: Too-Big-to-Fail Banks

If the nation defaults, then large institutions and other important financial firms could be directly affected by ratings cuts

With each day that passes, the August 2nd deadline for the U.S. to raise its debt ceiling gets closer. The financial sector should be getting nervous. If the nation defaults on its debt, then a downgrade by the rating agencies will send shockwaves throughout investment portfolios from Wall Street to Main Street. Although Treasuries will be the securities most obviously affected, other debt that enjoys explicit or implicit federal support will also face possible downgrade. In fact, the financial sector could be directly affected: the big banks still deemed "too big to fail" could face downgrades on their debt.

On Thursday, my colleague Megan McArdle noted that the rating agency Moody's said lots of different kinds of debt would be hit by a U.S. downgrade. Examples include municipal bonds and agency mortgage-backed securities, both of which are awarded high credit ratings in part due to the federal government's support. But the financial crisis taught us that a small group of large banks also enjoy an implicit federal guarantee. They could also face downgrades if the U.S. defaults.

According to a special comment released on Wednesday by Moody's, a sovereign debt downgrade would likely affect at least some of the too big to fail banks. The degree to which their debt ratings would be affected depends on how much U.S. support they are deemed to rely on. Here's the key chart from the Moody's report that precisely explains how a U.S. default would affect these banks:

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To understand the Moody's rating scale, Aaa is better than Aa1 which is better than Aa2. So in the case of JPMorgan, if the U.S. rating slips from Aaa one notch to Aa1, its long-term deposit rating would also slip a notch from Aa1 to Aa2. But under the same scenario, Bank of America's deposit rating would slip from Aa3 two notches to A2. The only bank on this list that would be entirely unaffected by a three notch U.S. downgrade to Aa3 is Goldman Sachs.

Rating agency Standard and Poor's hasn't been as clear on where it stands regarding these big banks. A letter released today that explained some consequences of a U.S. downgrade did not mention these banks. But additional ratings clarifications from the firm are expected, so we could yet see similar logic as Moody's on the too big to fail banks eventually.

In fact, just Tuesday, S&P released a report asserting that last year's financial regulation bill did not really preclude any chance of future bailouts for financial firms. So presumably, the agency still believes that U.S. support is a relevant factor when considering their long-term stability. Though, one of the bill's architects, Rep. Barney Frank (D-MA) rejected S&P's analysis, suggesting that the firm reconsider its "apparent decision to diversify into legislative analysis and political prognostication"

The two agencies also noted other financial institutions that would be susceptible to downgrade if U.S. debt is downgraded. For example, S&P mentioned "certain 'AAA' rated insurers" and "clearinghouses and central securities depositories" as the sorts of firms it will have to reevaluate. Moody's also named four large insurance companies that it would review, which could be affected by a multi-notch U.S. downgrade.

If these banks and other institutions receive debt downgrades due to a U.S. downgrade, then this could have significant effects across the financial sector. Investors would become nervous about their stability, and could begin to reminisce about the 2008 credit crunch. The derivatives market, in particular, could face some big problems. While the situation might not result in another financial crisis, it would surely have a detrimental impact on the U.S. economy.

Image Credit: REUTERS/Shannon Stapleton