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

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

“American banks are stronger today than they were three years ago,” said Gerard Cassidy, a bank equity analyst with RBC Capital Markets, adding that market prices have long reflected concerns raised by Moody's. “Yes, their ratings are lower, but is Citi tomorrow going to have to pay an extra 50 basis points for commercial paper? I don't think so.”

The prospect of downgrades had weighed on banks since Moody's said Feb. 15 it was reviewing 17 banks with capital- markets operations because of fragile confidence and tighter regulations that pinched revenue. Pressure mounted as Europe's sovereign-debt crisis intensified and cast doubt on the health of some of the continent's lenders.

By the time the results came out four months later, investors such as Thornburg Investment Management Inc.'s George Strickland said, the worst-case scenario for downgrades was already reflected in securities prices.

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

None of the financial firms was cut more than Moody's had forecast. Morgan Stanley's long-term senior unsecured debt rating was reduced two grades to Baa1, and nine other firms received two-level cuts, Moody's said yesterday in a statement. Credit Suisse's rating was cut three levels to A2 and Zurich- based UBS AG, 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 grade instead of two, while Barclays Plc was lowered two steps. Edinburgh-based Royal Bank of Scotland Group Plc was lowered one step, as was London-based Lloyds Banking Group Plc, Britain's biggest mortgage lender.

'Significant Exposure'

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

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

Credit-default swaps tied to Morgan Stanley dropped 20 basis points 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 earlier increase to as high as 400 basis points, according to prices compiled by data provider CMA. A basis point is 0.01 percentage point. Morgan Stanley's swaps are still 14 percent higher than they were on Feb. 15.

“To downgrade a BofA or Citigroup or companies that are sitting on hundreds of billions of dollars of cash in government-backed securities makes no sense,” Richard Bove, an analyst at Rochdale Securities LLC, said in an interview on Bloomberg Radio and Television's “Bloomberg Surveillance.”

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

The new A3 rating on Goldman Sachs's senior debt is the lowest in the history of the New York-based firm. Unsecured long- and short-term borrowing accounted for 25 percent of the company's liabilities at the end of March, while deposits accounted for just 6 percent, the bank's first-quarter financial statement shows.

Goldman Debt

Goldman Sachs's $4.25 billion in senior unsecured debt that matures in January 2022 yields 5.19 percent, or 362 basis points more than similar-maturity U.S. government debt, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

In March, a month after announcing its review, Moody's cut Sydney-based Macquarie Group Ltd. and Tokyo-based Nomura Holdings Inc. one level each. Nomura is the lowest rated of the 17 firms at Baa3, one grade above junk.

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

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

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

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

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

While bank stocks and bonds initially climbed yesterday, the downgrades may have longer-term effects on operations, forcing banks to post more collateral to trading partners in derivatives deals.

Derivatives Trading

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

“For the banks that are in the BBB category, I'm sure that will have a negative impact on their ratings sensitive businesses, like derivatives,” Anil Lalchand, a credit analyst at DoubleLine Capital LP in Los Angeles, which manages $35 billion, said in a telephone interview.

All the U.S. firms remained on negative outlook, which means their grades could be cut again, because government support may wane, Bob Young, managing director of North American banking for Moody's, said in an interview.

Morgan Stanley, owner of the world's biggest brokerage, avoided the largest potential downgrade because of possible support from Mitsubishi UFJ Financial Group Inc., according to Moody's. Morgan Stanley CEO James Gorman also cited his firm's capital ratios in meetings with Moody's to convince the ratings company that a three-level cut wasn't deserved.

“Management teams will always present as strong a case as they can,” 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's views global banks compared with smaller lenders. Minneapolis-based U.S. Bancorp, the fifth-largest U.S. bank by deposits, is still rated Aa3 by Moody's, five levels higher than Citigroup or Charlotte, North Carolina-based Bank of America.

Citigroup said in a statement that the downgrade was “arbitrary and completely unwarranted.” Morgan Stanley said its ratings don't reflect the actions it has taken to cut risk. Credit Suisse said it was pleased to remain among the top-rated large banks, while Bank of America said it has strengthened its capital and

“Funding for Credit Suisse shouldn't be a problem, said Thornburg's Strickland. ''Their short-term rating is still money-market eligible and their long-term rating is mid-tier A and as 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 in terms of capital, yet their ratings keep going down. What does that tell you? That the ratings were so wrong before.”

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