Moody’s Investors Service is taking a "wait and see" approach before cutting the credit ratings of some 17 global financial companies.  Three of the biggest Wall Street banks are particularly vulnerable - Morgan Stanley, Bank of America, and Citigroup.  Moody's will decide by mid-May whether to lower the ratings by 3 notches of, and for those banks that are hit, the results can be draconian. A 3-notch drop would place the affected banks at a level well below the ratings of JPMorgan Chase and similar rivals.  Such a move would affect the banks' dealings with counterparties and trading partners, with mutual funds, on longer-term derivatives trades, and on lost business relationships. Needless to say, the banks are scrambling to mitigate any ratings hit, which could impact the affected firms in several ways. Impact on Counterparties, Trading Partners. In view of lower ratings, it would not be surprising for counterparties or trading partners to lose confidence in any of these banks - after their credit risk policies and measurements raise red flags of caution.  can change the terms by which business is conducted.  A high credit rating enables banks to put up less money, which they can borrow cheaply, while a lower credit rating can mean they have to put up more money and perhaps pay more for their loans. The three banks that stand to be the most affected by a ratings downgrade have already said that they would have to put up billions of dollars more in collateral to back trading contracts. To the extent that a counterparty believes that the bank has serious credit risk issues and thus is vulnerable to liquidity issues - i.e., they might not be able to repay their debts when they come due - could prompt that counterparty or trading partner to reduce its exposure with the vulnerable bank.  They either call in an outstanding repurchase agreement, or reduce the amount they're willing to provide. Word of counterparty risk can spread like wild fire, which means that other counterparties and trading partners will take a similar stance.  Eventually, this can squeeze the profitable but liquidity-vulnerable bank to When that happens, news is likely  when determining how much exposure they want to have with vulnerable counterparties.  The moment one firm steps back and refuses to provide credit to a firm on the street, other firms follow suit.  Lacking sources on the Street for liquidity, the vulnerable firm often faces a life-and-death moment - and must decide whether to find a cash-rich partner or opt to close down.  This was the scenario for MF Global - and, with no buyer in sight, the firm filed for bankruptcy protection and liquidation. Impact on Mutual Funds. Weighing the creditworthiness and ratings of banks "is a major focus at Vanguard and at other buy-side companies who do business with Wall Street," said William Thum, a lawyer with the mutual fund giant Vanguard, referring to institutional investors like his company.  The country’s big mutual funds, asset managers and other institutions are reassessing their trading relationships in light of a possible ratings cut.  In some cases, contracts are being rewritten.  In others, big investors may walk away.  Some of the funds that he deals with are prohibited from trading with banks that have a less-than-sterling credit rating. Having a substantially lower credit rating than rivals, however, could do much wider damage over time.  It could affect billions of dollars in trading contracts that are an important business for Wall Street.  Many of these contracts demand that the company on the other side of a trade have a high enough credit rating. "We are now in the process of diversifying our list of trading partners by signing up new dealers who appear most likely to maintain relatively high credit ratings," he said.  Many of these contracts contain triggers that activate if a bank’s credit rating falls below predetermined levels.  When a ratings trigger is set off, a customer may have the right to terminate the trade, move it to another bank or demand that the bank post more collateral.  This can erode the profitability of the trade for the bank, which has to factor in the cost of the collateral.  It is very tricky to be a large trading bank with a rating below A. Impact on Derivatives Trades. Yet the impact of a downgrade will be felt deeply in the multitrillion-dollar market in derivatives, which are financial contracts that enable banks and their clients to make bets based on the movements of things like stocks, bonds, currencies and interest rates.  Derivatives trades that are set up to exist for more than five years would be the most vulnerable to downgrades.  In these trades, a bank’s customers are agreeing to expose themselves to the bank’s credit risk for a long time.  Long-term trades can also be the most profitable derivatives that a bank does. Most of the banks that dominate the derivatives market book nearly all their trades at commercial bank subsidiaries, which have higher ratings than their parent companies.  These bank subsidiaries at Citigroup and Bank of America might end up with an A3 rating after the threatened Moody’s downgrade — 2 notches above the Baa2 rating their parent companies could be saddled with.  Morgan Stanley’s bank subsidiary would fall the furthest, to a Baa1 rating. Citigroup appears to do essentially all of its derivatives trading through a bank, while Bank of America does three-fourths, according to figures published by the Office of the Comptroller of the Currency, a bank regulator. The picture is different at Morgan Stanley.  Less than 5% of its outstanding derivatives were booked at a commercial bank at the end of 2011, according to the figures.  Moving business to this subsidiary would take time and could require regulatory approval. The downgrade could speed up the shift of derivatives trades to central clearinghouses, something that is being pushed by regulators. "Moody’s may simply speed up something that is going to happen anyway," said one senior Wall Street executive who asked not to be named because he was not authorized to speak on the record. BofA, Citi in Stronger Positions. What may come as a surprise, is that these 2 banks are actually in a better position that Morgan Stanley, even though the 3 could be assigned the same low credit rating.  That's because both a supported by their higher-rated subsidiaries.  The potential problem for Citigroup and Bank of America is mitigated by the fact that much of their trading of contracts — bets on changes in interest rates, currency values and the like — is done through higher-rated subsidiaries. Morgan Stanley, Citigroup Respond. A Morgan Stanley spokeswoman, Jeanmarie McFadden, said the company had spent more than two years restructuring its business so that it was "less risky and less capital intensive," something that should help its rating.  She noted that in 2011 Standard & Poor’s gave Morgan Stanley an A-rating with a negative outlook, which was a downgrade but not nearly as severe as the one Moody’s is contemplating. Citigroup estimates that a 2-notch downgrade at the end of last year could have prompted additional cash and collateral needs of $5.4 billion.  Bank of America estimates that $4.5 billion of cash and collateral requirement on derivatives would be needed to cover a one-notch downgrade, but added that it had already posted $2.9 billion of that with customers.  Keith Horowitz, an analyst with Citigroup, says the banks have had some time to cushion the blow of a downgrade. Also troubling is the permanent loss of customers.  "Clients will take that long-dated business to JPMorgan or Goldman," said Brad Hintz, an analyst with Sanford C. Bernstein & Company.  "That’s a problem for Morgan Stanley."  Once they're gone, it's hard to get them back. For further details, go to:  [Dealbook, 3/29/12].