Why the credit downgrades will make banks riskier

June 22, 2012, 8:27 PM UTC

Fortune — There’s plenty of irony in the Moody’s downgrade of big U.S. banks. But here’s the biggest one: The lower ratings, which acknowledge that banks aren’t as safe as we thought they were, might actually make the banks riskier.

In one sense, the downgrades will do something that regulations have yet to accomplish. They’ll limit the banks’ ability to gamble their own money. The banks will have to hold more of their cash as collateral, meaning they won’t be able to give as much of it to London whales. It will also make it harder for banks to use the type of short-term financing that contributed to the bankruptcies of Lehman Brothers and MF Global.

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But in an increasingly important and enormous sector of the financial markets – derivatives — the downgrades might actually make the banking sector more dangerous.

After the downgrades, there are two camps when it comes to the U.S.’s largest banks. It’s JPMorgan Chase (JPM) and Goldman Sachs (GS), which now have A ratings, on the high ground, and Morgan Stanley (MS), Bank of America (BAC) and Citigroup (C), which now have a Baa rating, that are going to be forced to pitch their tents at base camp. (Wells Fargo is also in the higher group, but they aren’t big in the derivatives business.)

Ratings don’t matter much in lending. Banks get most of their money to lend from deposits, which are backed mostly by the FDIC and, as a result, Uncle Sam. So the credit downgrades are unlikely to make anyone switch their money from Bank of America or Citibank to Chase.

But in the world of derivatives, ratings matter a lot. Derivatives are a huge — by some measures as large as $600 trillion — and potentially risky business. It’s the business that led AIG to bailout. In general, derivatives are bets that banks and investors place on interest-rates, commodities and bonds. And they mostly go unfunded, meaning the bulk of the money on the line doesn’t exchange hands until after the bet is closed.

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Large banks don’t typically post initial collateral when they trade derivatives with hedge funds, pension funds and other buy-side firms. They do have to post follow-on collateral when those trades fall in value and when they trade with other banks, and will have to post more after the downgrades. But initial collateral for those trades comes from the buy-side firms. And when the banks go out of business, it’s the hedge funds’, sovereign-wealth funds’ and pension funds’ money that is on the hook. As a result, all things being equal, hedge funds will trade with the highest rated firm.

A person in charge of clearing trades at one of the world’s largest hedge funds said the ratings changes would defiantly affect where his firm and others trade. “Buy-side firms will look at the downgrades and see Morgan Stanley sliding toward Lehman,” he said. “Why would I want that risk?”

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What’s more, because firms with higher credit ratings have to post less follow-on collateral, they can also offer better derivative pricing.

That means the new ratings split is likely to further migrate this potentially risky business, to the ratings high-ground — namely at JPMorgan and Goldman — making the potential losses even larger and more unmanageable, without a bailout, that is.

There is one hope. As part of the Dodd-Frank rules, regulators have been pushing for the bulk of derivative trades to be run through central clearing houses. Clearing levels the playing field among firms, because everyone, including the banks, have to post the same amount of collateral no matter what their credit rating is.

Wall Street has been fighting the rules, which are mostly written and could go in place as soon as the end of the year. But now that the credit downgrades put Morgan Stanley and others at a disadvantage, those firms might get behind the effort to centrally clear derivative trading. The result could be to disperse the business among more firms, spreading the risk.

But even if the clearing crowd and regulators win this round, that won’t last for long. Wall Street is sure to come up with some other over-the-counter, highly structured investment that won’t fall under the current definition of a derivative. It always does. The unregulated products are always the most profitable for the banks. And whatever that is, because of the credit ratings, it will mostly be traded by JPMorgan and Goldman. And when it eventually blows up, you know who will have to pay for it: you and I.