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Closing the Barn Door Too Late? Banks Are Healthier Now than in 2007. Yet Moody's Recently Downgraded 17 Banks. Why?

Closing the Barn Door Too Late? Banks Are Healthier Now than in 2007. Yet Moody's Recently Downgraded 17 Banks. Why?

The other day, I excerpted research by Rochdale Securities analyst Richard Bove about how much stronger banks are today than they were in 2007. Balance sheets are prettier, quality of assets are bettter, quality of capital is stronger and the like. Bove concluded many bank stocks were a buy. Well, Brad Hintz, a senior analyst and former Lehman CFO (many, many years before its blow up!) of Bernstein Research's on why Moody downgraded 17 banks last week. Turns out Hintz and his team actually talked to Moody's about the reasons for the downgrades.

Hintz says: "On a purely quantitative basis, the U.S. capital markets banks are financially stronger than they have been in years. Leverage is down both on a GAAP basis and on a risk weighted assets basis. The quality of bank capital has improved, there is more common equity and less subordinated and preferred equity. The banks’ legacy (i.e. troubled) assets are largely gone. The proportion of Level 3 assets has fallen while the proportion of Level 1 assets has increased. The banks’ risk management functions, credit functions, treasury activities, repo desks and the Audit Committees of the Boards have strengthened. There are Federal Reserve officials sitting in the banks' head offices to provide advice and guidance. There is regular reporting of derivatives positions, credit risk and counterparty risk to Washington authorities.

"But Moody's has explained to Bernstein that the lessons from the 2007-2009 crisis taught their credit

committees that:

- All major financial institutions are bound together through trading, settlement and derivatives relationships. Thus, a credit event at one firm can be passed through to all the other firms like a line of dominos.

- Wholesale funding at a bank can unwind quickly. Commercial paper, uncommitted bank lines, long-term debt, term demand notes, tri-party repo, securities lending, bond borrows and prime brokerage customer cash can and likely will be withdrawn during 'black swan' tail events.

- Elegant hedges and sophisticated risk management metrics can fail when markets become illiquid or when market sectors become near-perfectly correlated.

- Regulatory rules do not always work as designed. Regulators do not have unlimited authority to save financial institutions1 and there is little appetite in the political power centers on either side of the Atlantic to save the banks a second time."

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