Brooke’s Note: When Standard & Poor’s famously downgraded U.S. debt in August, Moody’s and Fitch, the two other big ratings agencies, steadfastly declined to go that far with the sacred cow of investments and kept their triple-A ratings in place. See: What RIAs need to know about the Standard & Poor’s downgrade of US debt. But what do Moody’s and Fitch think? I had that question in the back of my mind when Jeremy Fletcher proposed taking notes last Monday at the Fitch conference that came here to the Bay area. Fletcher (whose office is next door to ours in Mill Valley) manages portfolios — mostly bonds — for Asset Dedication LLC, whose clients consist of investors using RIAs and other financial advisory firms.

On Oct. 3, Fitch Solutions held an afternoon seminar at the Omni Hotel in San Francisco for a group of about 30 of its clients to discuss the U.S. banking sector. Most attendees were buy-side institutional credit analysts. I attended because a large number of the corporate bonds available for our clients are financials, and I thought it would be useful to hear their outlook for the sector given the changes the Dodd-Frank Act and Basel III are imposing.

In its presentation, titled “U.S. Credit, Counterparty & Liquidity Risk,” Fitch expressed the view that the European debt problems will not be a large threat to U.S. banks. It predicted that the economy will be weak in the next year or two, loan and revenue growth will be slow and financial margins will continue to compress. However, its rating outlook for the banking sector (as opposed to its view on financial performance) is stable.

The challenge of Dodd-Frank

The main challenges to U.S. banks will be responding to Dodd-Frank and Basel III requirements.

“The Federal Reserve is committed to the promulgation of rules that are economically sensible, appropriately weigh costs and benefits, protect smaller community institutions and, most important, promote the sound extension of credit in the service of economic growth and development.”

-Ben Bernanke, July 21, 2011

How are the Fed and other agencies designated to implement Dodd-Frank doing with their commitments? Mario Onorato, senior director and head of balance sheet and capital management for Toronto-based Algorithmics, had interesting points to make about that at the Fitch event, citing a Davis Polk Dodd-Frank rule making progress report issued in June 2011.

In one year the agencies had more than 1,700 meetings with the public. But they had completed only 20% of the 163 required rules and missed 104 deadlines. The cumulative cost to implement Dodd-Frank is estimated at $2.9 billion over five years. Smaller community institutions may have trouble raising the additional capital needed, and credit does not seem to be reaching borrowers any faster. So some might claim Bernanke is 0 for 4.

The proposed Volcker Rule would allow banks to trade repurchase agreements and securities lending, but not to trade futures. Bank chief executives might have to attest in writing that their organizations are not engaging in proprietary trading (perhaps analyzed through a central database, which could allow leaks). If enacted under its current state, it would be unique in the world and further handcuff U.S. banks relative to foreign competitors. U.S. corporate tax rates already greatly exceed those in Europe and elsewhere.

Raising capital

The cost of complying with Dodd-Frank appears to weigh more heavily on small to midsize banks. Larger institutions, despite having greater capital surcharges, are more likely to be able to tap the credit markets to fund their capital needs. Small and midsize banks may find it more difficult to raise capital; the new regulations limit their access, exclude certain capital securities such as trust preferreds, and will increase their costs.

The changes to the Basel III international bank capital and liquidity requirements will not be as substantial for large??banks. Risk-weighted assets go up significantly for large banks (e.g., JPMorgan Chase & Co. and Citigroup Inc.) but much less so for smaller banks. Overall capital liquidity is already fairly well established and U.S. banks are likely well prepared for the changes, since discussions on the requirements have gone on for some time.

One notable point of contention, says Fitch, is that Basel III counts Treasuries distinct from the debt securities of government-sponsored entities such as the Government National Mortgage Association and Federal Farm Credit Banks). While GSEs Fannie Mae and Freddie Mac are not on the government budget, they have been considered effectively guaranteed since September 2008, when the government placed them in conservatorship.

Good news

The good news: Fitch does not see much direct U.S. bank exposure to the European debt problems. Most of the banks’ direct exposure in Portugal and Ireland is limited to lending to U.S. subsidiaries in those countries. Exposure to Spain and Italy is more significant.

However, Fitch sees the real issue as being counterparty risk, or relationships with European banks. Despite the relative lack of direct risk, in the event of a banking crisis in Europe, U.S. banks could still be affected. They might see their liquidity dry up overnight as European banks are forced to raise cash to meet short-term obligations. The banking system as a whole is interdependent; that many sudden trades could shock the system. If the U.S. banks were unable to get payments or settle trades from European banks that day, they would also be forced to make sudden trades in a rippling effect. A similar dynamic happened when Lehman Brothers Holdings Inc. failed.

Finally, Fitch introduced a new series of products to hedge against bank counterparty risk. It has developed credit default swap indexes tied to the banking sector as a whole; they can also be customized. This allows the buying of credit protection for names that do not have individually traded CDS, since they will likely move in tandem with the whole banking sector.

Other speakers at the Fitch event included Diana Allmendinger, a director of Fitch Solutions (on CDS), and Christopher Wolfe, a managing director of Fitch Solutions (on the U.S. banking outlook).

Jeremy Fletcher is a senior portfolio manager for Asset Dedication LLC of Mill Valley, Calif. He can be reached at fletcherj@assetdedication.com

Editor’s Note: If you have the opportunity to be a fly on the wall at an event where there is information you think may be of interest to a wider RIA business audience, please email me at brooke@riabiz.com and suggest it. I’ll likely send you with a notebook.