Let's skip ahead to Aug. 3. The debt ceiling hasn't moved an inch and the United States no longer enjoys a coveted triple-A credit rating. Now what?
Such a downgrade could deliver a massive economic hit, affecting the quality of banks' assets – including residential MBS -- and the value of their swollen investment portfolios, economists and other observers say.
The timing couldn't be worse, as asset quality has been steadily improving. But a major macroeconomic change could rattle all of that.
"The outlook on credit, obviously, is hard to determine because there are so many macro events going on in the overall market," Edward Wehmer, the president and chief executive of Wintrust Financial Corp., said during his company's quarterly conference call with analysts this week. "Who knows what Washington is going to do and whether they've tossed us back into a double dip. Then all bets are off."
On Thursday, executives from the nation's largest banks, brought together by the Financial Services Forum, echoed Wehmer's sentiments in a letter sent to the White House and Congress urging both to take action.
Economists also say a downgrade could wreak havoc on the investment portfolios of banking companies – which control a lion’s share of the residential mortgage market. That threat starts with interest rate risk, particularly for banks that have reached for longer-term maturities in hopes of bigger yields.
A downgrade "will cause rates to rise, which will in turn hurt the market value of bond portfolios," said Kevin Jacques, the chairman of finance at Baldwin-Wallace College and a former economist at the Treasury Department.
"It is a relatively simple story that gives you interest rate risk," Jacques added. "If they are sitting there looking at the balance sheet but haven't hedged it, the rates rise and they get slammed. It happened in 1994 when the Fed raised rates unexpectedly and big banks got slammed."
William Haraf, the commissioner for the California Department of Financial Institutions, said banks need to be prepared. "If I was a banker, I would be getting ready by shortening up my positions and getting heavy on cash," he said in an interview Wednesday.
A downgrade could prompt a slew of mark-to-market issues as the underlying value of certain investments drop, observers said.
"Interest rate risk on the securities can be significant since they tend to be fixed. A default could cause a significant jump in interest rates, resulting in mark to market hits," Sabeth Siddique, a director at Deloitte & Touche LLP and a former assistant director of banking supervision and regulation at the Federal Reserve Board, said by email Thursday.
FIG Partners LLC wrote in a July 23 blog that a downgrade could change the risk weighting of Treasury bonds and other government-backed securities. It could inflate a bank's risk-weighted assets, a denominator for several capital calculations, effectively lowering capital ratios. As it stands, such securities get a 0% risk weighting because they are viewed as safe bets.
The effects could be mild for most banks, but could be particularly detrimental for those already struggling.