Three Major Banks Prepare for Possible Credit ...

Some of Wall Street's biggest banks are bracing for fallout from a possible cut in their credit ratings.

Moody's Investors Service, one of the two big ratings agencies, has said it will decide in mid-May whether to lower its ratings for 17 global financial companies. Morgan Stanley, which was hit hard in the financial crisis, appears to be the most vulnerable. Moody's is threatening to cut the bank's ratings by three notches, to a level that would be well below the rating of a rival like JPMorgan Chase.

Bank of America and Citigroup may also fall to the same level as Morgan Stanley, but those two are helped by having higher-rated subsidiaries.

Credit ratings are particularly important for financial companies, which greatly depend on the confidence of their creditors and the companies they trade with. A high credit rating enables banks to put up less money, which they can borrow cheaply, while a lower credit rating can mean they have to put up more money and perhaps pay more for their loans.

The three banks that stand to be the most affected by a ratings downgrade have already said that they would have to put up billions of dollars more in collateral to back trading contracts.

Having a substantially lower credit rating than rivals, however, could do much wider damage over time. It could affect billions of dollars in trading contracts that are an important business for Wall Street. Many of these contracts demand that the company on the other side of a trade have a high enough credit rating.

The country's big mutual funds, asset managers and other institutions are reassessing their trading relationships in light of a possible ratings cut. In some cases, contracts are being rewritten. In others, big investors may walk away.

Weighing the creditworthiness and ratings of banks "is a major focus at Vanguard and at other buy-side companies who do business with Wall Street," said William Thum, a lawyer with the mutual fund giant Vanguard, referring to institutional investors like his company.

Some of the funds that he deals with are prohibited from trading with banks that have a less-than-sterling credit rating.

"We are now in the process of diversifying our list of trading partners by signing up new dealers who appear most likely to maintain relatively high credit ratings," he said.

Not all contracts would be affected by a downgrade by Moody's. Many also require a similar action from the other major ratings agency, Standard & Poor's. And Moody's may not cut as deeply as was warned, or at all.

But if Moody's does cut as it warned in February, Morgan Stanley, Bank of America and Citigroup would be rated Baa2 - just two notches above speculative, or junk - and the banks would have weaker credit ratings than major rivals.

The potential problem for Citigroup and Bank of America is mitigated by the fact that much of their trading of contracts - bets on changes in interest rates, currency values and the like - is done through higher-rated subsidiaries.

Morgan Stanley noted that only about 8 percent of its over-the-counter derivative trading contracts would be affected by a three-notch downgrade.

Still, the company has spoken to trading partners about rewriting contracts to allow for more leeway on credit quality and has had internal discussions about moving some trading activities to a bank subsidiary that has a slightly better rating than the company, according to people briefed on these discussions but not authorized to speak on the record.

James P. Gorman, chief executive of Morgan Stanley, has met with Moody's several times since February to try to limit the fallout of any ratings move, according to these people.

A Morgan Stanley spokeswoman, Jeanmarie McFadden, said the company had spent more than two years restructuring its business so that it was "less risky and less capital intensive," something that should help its rating. She noted that in 2011 Standard & Poor's gave Morgan Stanley an A- rating with a negative outlook, which was a downgrade but not nearly as severe as the one Moody's is contemplating.

Morgan Stanley's executives, she added, have "done extensive planning and are fully prepared for potential ratings downgrade scenarios."

A Citigroup spokesman, Jon Diat, said: "Our clients tend to be more sophisticated in their analysis than to rely solely on ratings from a single agency. While some clients might note any changes in ratings from Moody's, we don't believe the impact would be material."

A spokesman for Bank of America declined to comment.

Mr. Gorman's involvement in talks with Moody's is hardly surprising. In recent financial filings, the banks disclosed some estimates of the extra financial burden of downgrades, though the estimates may not capture the full impact across all businesses.

If Moody's and Standard & Poor's had both rated Morgan Stanley the equivalent of Baa2 at the end of last year, the bank has estimated it might have had to post $6.5 billion to finance additional collateral pledges and payments to terminate contracts.

Citigroup estimates that a two-notch downgrade at the end of last year could have prompted additional cash and collateral needs of $5.4 billion. Bank of America estimates that $4.5 billion of cash and collateral requirement on derivatives would be needed to cover a one-notch downgrade, but added that it had already posted $2.9 billion of that with customers.

Keith Horowitz, an analyst with Citigroup, says the banks have had some time to cushion the blow of a downgrade.

"Given large liquidity pools and several years to prepare, we believe all of the banks are positioned to manage a downgrade," he said.

Yet the impact of a downgrade will be felt deeply in the multitrillion-dollar market in derivatives, which are financial contracts that enable banks and their clients to make bets based on the movements of things like stocks, bonds, currencies and interest rates.

Many of these contracts contain triggers that activate if a bank's credit rating falls below predetermined levels. When a ratings trigger is set off, a customer may have the right to terminate the trade, move it to another bank or demand that the bank post more collateral. This can erode the profitability of the trade for the bank, which has to factor in the cost of the collateral.

It is very tricky to be a large trading bank with a rating below A.

Derivatives trades that are set up to exist for more than five years would be the most vulnerable to downgrades. In these trades, a bank's customers are agreeing to expose themselves to the bank's credit risk for a long time. Long-term trades can also be the most profitable derivatives that a bank does.

"Clients will take that long-dated business to JPMorgan or Goldman," said Brad Hintz, an analyst with Sanford C. Bernstein & Company. "That's a problem for Morgan Stanley."

Most of the banks that dominate the derivatives market book nearly all their trades at commercial bank subsidiaries, which have higher ratings than their parent companies.

These bank subsidiaries at Citigroup and Bank of America might end up with an A3 rating after the threatened Moody's downgrade - two notches above the Baa2 rating their parent companies could be saddled with. Morgan Stanley's bank subsidiary would fall the furthest, to a Baa1 rating.

Citigroup appears to do essentially all of its derivatives trading through a bank, while Bank of America does three-fourths, according to figures published by the Office of the Comptroller of the Currency, a bank regulator.

The picture is different at Morgan Stanley. Less than 5 percent of its outstanding derivatives were booked at a commercial bank at the end of 2011, according to the figures. Moving business to this subsidiary would take time and could require regulatory approval.

The downgrade could speed up the shift of derivatives trades to central clearinghouses, something that is being pushed by regulators.

"Moody's may simply speed up something that is going to happen anyway," said one senior Wall Street executive who asked not to be named because he was not authorized to speak on the record.

Michael J. de la Merced contributed reporting

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