U.S. banks face rising risk from European crisis, Fitch warns

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Big U.S. banks have cut back their financial ties to Europe over the last year or more but still could be “greatly affected” if the continent’s debt crisis spreads, credit rating firm Fitch Ratings said in a new report.

The five-page report, issued about an hour before Wall Street’s closing bell Wednesday, helped trigger a sudden plunge in bank shares that dragged down the stock market overall.

The Dow Jones industrial average ended the day down 190.57 points, or 1.6%, to 11,905.59. Among the banking titans, shares of Bank of America slumped 3.8%, JPMorgan Chase also fell 3.8%, Citigroup lost 4.1% and Goldman Sachs dropped 4.2%.

The Fitch report doesn’t suggest that U.S. banks will need another government bailout anytime soon but uses language that brings back memories of how quickly things went bad in 2008.

“Currently, Fitch’s rating outlook for the U.S. banking industry is stable, reflecting improved fundamentals at most banks, coupled with generally lower ratings versus pre-crisis levels,” the firm said. But “Fitch believes that, unless the Eurozone debt crisis is resolved in a timely and orderly manner, the broad outlook for U.S. banks will darken.”

That’s the problem: No resolution appears in sight, and in recent days worried investors have been dumping bonds of even the financially strongest countries, including France, Austria and Finland.

Some of the key issues Fitch raises:

-- The six biggest banks (the four named above, plus Wells Fargo and Morgan Stanley) have total net exposure of about $50 billion to the five most financially stressed markets -- Greece, Ireland, Italy, Portugal and Spain. “Exposure” includes amounts on deposit, loans outstanding, securities held and other items.

That exposure averaged 0.5% of the banks’ assets and less than 9% of their so-called Tier 1 capital, Fitch said. “Overall, net exposure appears manageable but not without financial costs,” the firm said.

-- The banks have hedged part of their European exposure with credit default swaps, which are insurance contracts that pay off if a debtor defaults. But swaps may not be triggered if creditors agree to voluntary losses by forgiving a portion of an issuer’s debt, which is what has happened with Greece.

Hence, the tactic of hedging with swaps “could prove problematic if voluntary debt forgiveness becomes more prevalent and CDS contracts are not triggered,” Fitch said.

-- Some of the banks also are exposed to Europe’s woes because they are parent companies of money market mutual funds, which invest in short-term debt issued by banks and companies worldwide.

“While not contractually required, banks oftentimes offer support to affiliated money market funds in the event of a need,” rather than risk reputational damage, Fitch said.

-- The banks’ revenue from capital market activity, such as trading securities and advising on mergers, could be hit if Europe’s situation worsens. For banks that disclose regional breakdowns, “Revenues generated from European capital markets activities generally hover around one-third of total capital markets revenue,” Fitch said.

Overall, the report didn’t tell Wall Street anything it didn’t already know. But in a market that just trades from headline to headline, Fitch gave investors and traders an excuse to sell first and ask questions later.

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Europe’s mess gives U.S. a reprieve on debt comeuppance

-- Tom Petruno