Downgrades of Morgan Stanley, Credit Suisse Group AG and 13other global banks, announced by Moody's Investors Service aftermonths of speculation about dire fallout, were met instead byrallies in stocks and bonds.

The cost to protect Morgan Stanley's debt against lossesdropped, and the shares rallied as much as 4.6 percent in extendedtrading yesterday after the ratings firm cut the bank by two levelsrather than a threatened three grades. Credit-default swaps tied toBank of America Corp., which was lowered to within two levels ofjunk along with Citigroup Inc., also improved, along with those ofGoldman Sachs Group Inc.

“American banks are stronger today than they were three yearsago,” said Gerard Cassidy, a bank equity analyst with RBC CapitalMarkets, adding that market prices have long reflected concernsraised by Moody's. “Yes, their ratings are lower, but is Cititomorrow going to have to pay an extra 50 basis points forcommercial paper? I don't think so.”

The prospect of downgrades had weighed on banks since Moody'ssaid Feb. 15 it was reviewing 17 banks with capital- marketsoperations because of fragile confidence and tighter regulationsthat pinched revenue. Pressure mounted as Europe's sovereign-debtcrisis intensified and cast doubt on the health of some of thecontinent's lenders.

By the time the results came out four months later, investorssuch as Thornburg Investment Management Inc.'s George Stricklandsaid, the worst-case scenario for downgrades was already reflectedin securities prices.

“If anything, the market is reacting with relief,” saidStrickland, who helps oversee $14 billion of fixed-income assets asa managing director at Santa Fe, New Mexico-based Thornburg. MorganStanley bonds likely will rally, said Strickland, whose firm ownsthe bank's debt. “The market is shrugging it off.”

None of the financial firms was cut more than Moody's hadforecast. Morgan Stanley's long-term senior unsecured debt ratingwas reduced two grades to Baa1, and nine other firms receivedtwo-level cuts, Moody's said yesterday in a statement. CreditSuisse's rating was cut three levels to A2 and Zurich- based UBSAG, the other firm singled out for a potential three- level cut,was lowered two instead.

HSBC Holdings Plc, Europe's largest bank, was lowered one gradeinstead of two, while Barclays Plc was lowered two steps.Edinburgh-based Royal Bank of Scotland Group Plc was lowered onestep, as was London-based Lloyds Banking Group Plc, Britain'sbiggest mortgage lender.

'Significant Exposure'

“All of the banks affected by today's actions have significantexposure to the volatility and risk of outsized losses inherent tocapital-markets activities,” Greg Bauer, Moody's global bankingmanaging director, said in the statement.

The 43-member Bloomberg Europe Banks and Financial ServicesIndex erased earlier losses and rose 1 percent to 73.63 as of 12:22p.m. in London trading. Barclays was up 0.5 percent at 203.25pence, RBS gained 0.6 percent to 244.80 pence and Credit Suisseadvanced 0.3 percent to 18.11 francs in Zurich.

Credit-default swaps tied to Morgan Stanley dropped 20 basispoints after the announcement to a mid-price of 370 basis points,said market participants familiar with the trades. The contracts,which decline as investor confidence improves, reversed an earlierincrease to as high as 400 basis points, according to pricescompiled by data provider CMA. A basis point is 0.01 percentagepoint. Morgan Stanley's swaps are still 14 percent higher than theywere on Feb. 15.

“To downgrade a BofA or Citigroup or companies that are sittingon hundreds of billions of dollars of cash in government-backedsecurities makes no sense,” Richard Bove, an analyst at RochdaleSecurities LLC, said in an interview on Bloomberg Radio andTelevision's “Bloomberg Surveillance.”

“You can forget Moody's,” Bove said. “You should have forgottenthem a long time ago.”

The new A3 rating on Goldman Sachs's senior debt is the lowestin the history of the New York-based firm. Unsecured long- andshort-term borrowing accounted for 25 percent of the company'sliabilities at the end of March, while deposits accounted for just6 percent, the bank's first-quarter financial statement shows.

Goldman Debt

Goldman Sachs's $4.25 billion in senior unsecured debt thatmatures in January 2022 yields 5.19 percent, or 362 basis pointsmore than similar-maturity U.S. government debt, according toTrace, the bond-price reporting system of the Financial IndustryRegulatory Authority.

In March, a month after announcing its review, Moody's cutSydney-based Macquarie Group Ltd. and Tokyo-based Nomura HoldingsInc. one level each. Nomura is the lowest rated of the 17 firms atBaa3, one grade above junk.

“Moody's is not going to detect some problem in advance and movea rating to warn the public,” said Ken Fisher, chief executiveofficer and founder of Woodside, California-based FisherInvestments, which has about $44 billion under management. “Whetherit's a stock or a bond, the free market already did that. Moody'sgoes along afterwards and effectively validates what the market'salready done.”

While higher-rated banks such as JPMorgan Chase & Co. andHSBC received credit for retail businesses that serve as “shockabsorbers” from the volatility of capital-markets-related units,Bank of America and Citigroup's consumer divisions were “thinner orless reliable” cushions, Moody's said.

Bank of America, which incurred more than $40 billion inmortgage and foreclosure costs since 2007, may face more losses onhome loans, Moody's said. New York-based Citigroup is still tryingto wind down more than $200 billion of unwanted assets.

Large U.S. banks had ratings of Baa1 or lower — similar to BBBat Standard & Poor's — in the 1980s and early 1990s, said DavidHendler, an analyst at CreditSights Inc. in New York. That erafollowed Latin America's sovereign-debt defaults of the 1980s,which forced lenders to set aside funds to cover bad loans tocountries there.

“It's almost like they've come full circle back to triple- B,”Hendler said. “The industry has been through a triple-B phasebefore, and they will come back from it.”

While bank stocks and bonds initially climbed yesterday, thedowngrades may have longer-term effects on operations, forcingbanks to post more collateral to trading partners in derivativesdeals.

Derivatives Trading

Citigroup and Bank of America, as the lowest-graded firms afterNomura, may be at a disadvantage in businesses such as tradingderivatives that aren't centrally cleared. That market providesabout 15 percent of the industry's trading revenue, Kinner Lakhani,a Citigroup analyst, wrote in an April 30 note. Both firms lostmarket share among the top nine banks in fixed- income trading lastyear, according to Bloomberg Industries.

“For the banks that are in the BBB category, I'm sure that willhave a negative impact on their ratings sensitive businesses, likederivatives,” Anil Lalchand, a credit analyst at DoubleLine CapitalLP in Los Angeles, which manages $35 billion, said in a telephoneinterview.

All the U.S. firms remained on negative outlook, which meanstheir grades could be cut again, because government support maywane, Bob Young, managing director of North American banking forMoody's, said in an interview.

Morgan Stanley, owner of the world's biggest brokerage, avoidedthe largest potential downgrade because of possible support fromMitsubishi UFJ Financial Group Inc., according to Moody's. MorganStanley CEO James Gorman also cited his firm's capital ratios inmeetings with Moody's to convince the ratings company that athree-level cut wasn't deserved.

“Management teams will always present as strong a case as theycan,” Young said. “We undertake a very thorough, very thoughtful,very deliberate analysis of each individual institution.”

The rating cuts underscore how much less creditworthy Moody'sviews global banks compared with smaller lenders. Minneapolis-basedU.S. Bancorp, the fifth-largest U.S. bank by deposits, is stillrated Aa3 by Moody's, five levels higher than Citigroup orCharlotte, North Carolina-based Bank of America.

Citigroup said in a statement that the downgrade was “arbitraryand completely unwarranted.” Morgan Stanley said its ratings don'treflect the actions it has taken to cut risk. Credit Suisse said itwas pleased to remain among the top-rated large banks, while Bankof America said it has strengthened its capital and

“Funding for Credit Suisse shouldn't be a problem, saidThornburg's Strickland. ''Their short-term rating is stillmoney-market eligible and their long-term rating is mid-tier A andas good as almost any bank.”

The reductions by Moody's are “a mea culpa from 2007 and 2008,”said James Leonard, a credit analyst in Chicago at Morningstar Inc.“The banks have gotten so much better in the last few years interms of capital, yet their ratings keep going down. What does thattell you? That the ratings were so wrong before.”

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