European Banks Could Be Headed For Downgrades

Moody's Investors Service announced on Tuesday that the subordinated debt of 87 banks from 15 European countries is at risk of downgrade. Moody's blamed the possible bank downgrades on the reduced likelihood that the banks would receive state support in the event of a banking collapse. Eurozone members like Greece, Italy, Spain and even France have seen their borrowing costs climb uncomfortably higher as investors lose confidence in the eurozone. Several countries in the European Union have introduced unpopular austerity measures aimed at lowering fiscal deficits by raising taxes and cutting costs. Moody's said that many of these countries are now facing "an increasingly stark trade-off between the need to preserve confidence in their banking systems and the need to protect their own balance sheets." In such an environment, it would be much more difficult for a government to justify bailing out a failed bank with taxpayer money. The ratings agency also said that "systemic support for subordinated debt may no longer be sufficiently predictable or reliable to be a sound basis for incorporating uplift into Moody's ratings." The Moody's warning made holding subordinated debt from a European bank even more risky than before. Holders of subordinated debt have a place at the back of line if a failed bank declares bankruptcy and makes plans to pay back its creditors. ACTION ITEMS:

Bullish:
Traders who believe that the eurozone banking system will recover might want to consider the following trades:

• European banking stocks like Deutsche Bank DB and Banco Santander STD could climb higher if the eurozone is able to prevent a financial collapse and protect the banking sector.

The iShares MSCI Europe Financials EUFN ETF could also climb higher if the eurozone is preserved and the banks can get through the current liquidity crisis unscathed. Bearish:
Traders who believe Moody's warning of possible bank downgrades is warranted may consider alternate positions:

• The ProShares UltraShort MSCI Europe EPV ETF could climb higher if the liquidity crisis worsens due to the Moody's downgrade warning and banks are unable to provide the private sector with the credit needed to keep European economies growing.

• The ProShares UltraShort Euro EUO could also see significant gains under such a scenario, as investors lose confidence in the eurozone and move assets elsewhere.

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