What's Behind the Bank of America, Citi, and Wells Fargo Downgrades?

Moody's says that a rescue is now a little less likely, but is it underestimating Congress's new-found hatred of bailouts?

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Did last summer's financial regulation bill work to end the too big to fail problem after all? By looking at the downgrade news out of Moody's, you might think so. The firm has cut ratings of three major banks: Bank of America, Citigroup, and Wells Fargo. Although the particular downgrades differed by bank, Moody's rationale was the same for all three: it sees a government rescue of these banks as a little bit less probable. How safe are taxpayers from future bailouts?

What Moody's Actually Said

Here's a key excerpt from Moody's downgrade note for Bank of America:

Moody's continues to see the probability of support for highly interconnected, systemically important institutions as very high, although that probability is lower than it was during the financial crisis. During the crisis, the risk of contagion to the US and global financial system from a major bank failure was viewed as too great to allow such a failure to occur -- a view borne out in the aftermath of the Lehman failure. This led the government to extend an unusual level of support to weakened financial institutions and Moody's to incorporate the expectations of such support in its ratings. Now, having moved beyond the depths of the crisis, Moody's believes there is an increased possibility that the government might allow a large financial institution to fail, taking the view that contagion could be limited.

So the decision was in large part due to the simple fact that Moody's doesn't see the U.S. on the brink of financial crisis any longer. As a result, if one of these firms were to fail, then the government is probably in a better position to let that happen.

But Moody's later notes the potential effect of the new non-bank resolution authority, established by last summer's financial regulation bill. This new function provides the government the ability to wind down large failing financial firms. The Moody's note cautiously applauds the effort. Moody's says that if it works as intended, then these big banks will, indeed, fail. But it also notes -- that' s a big "if." There are still some significant kinks in the new mechanism to be worked out.

What Moody's Should Also Consider (And May Be)

The rating agencies tend not to comment on party politics. But Moody's should be considering the extent to which the rise of the Tea Party has changed the equation. The current makeup of Congress should influence its view on the probability of a bailout. Back in 2008, we had a left-leaning Congress. And yet, even it balked at first when the bailout was proposed.

Now imagine if you had today's House of Representatives in place back in 2008. This is the same House that barely agreed to raise the debt ceiling before an effective default occurred. If President Obama proposed a bailout of the big banks now, would the Tea Party Republicans really go along? Call me a cynic, but I think they'd take their chances and face the consequences of financial collapse. Some in Congress who voted for the bailout in 2008 even claim that they regret their decision.

Does this reality enter Moody's calculations? Frankly, the political calculus might be more important to the likelihood of bailout than a new regulatory mechanism. Moody's continues to see a high probability of bailout, but given the current makeup of Congress, it's hard to understand why.

Image Credit: REUTERS/Mike Segar