Standard & Poor’s Wednesday downgraded its ratings or revised its outlooks on 22 U.S. banks — more than half of which have provided letters of credit on municipal securities — to reflect the ongoing change in the banking industry.

Standard & Poor’s said it expects less favorable operating conditions, greater volatility and tighter regulations to have an impact on the industry. The rating agency also said the actions reflect it “ongoing broad-range reassessment of industry risk for U.S. financial institutions.”

“While the market may be viewing the sector rather favorably in the past few weeks, our fundamental analysis suggests more pain is to come,” analyst Rodrigo Quintanilla said in a teleconference yesterday.

The downgrades impacted both Wells Fargo & Co. and U.S. Bancorp — parents of some of the municipal market’s most active letter-of-credit providers — although both retain their top-notch, A-1-plus short-term ratings.

Wells Fargo Bank and Wachovia Bank — which Well Fargo acquired — were both downgraded to AA from AA-plus and removed from negative watch and given negative outlooks. U.S. Bank was downgraded to AA-minus from AA-plus and given a stable outlook.

Wells Fargo and Wachovia together since 2004 have provided 519 letters of credit with a par value of $15.1 billion, ranking third overall among LOC providers in that period, according to Thomson Reuters. U.S. Bank has provided 490 letters of credit on debt with a par value of $11.6 billion, ranked fourth overall.

Overall, 16 of the banks affected by Standard & Poor’s rating actions or outlook revisions have written LOCs since 2004. Combined they have provided 1,732 LOCs with a par value of $39.04 billion since 2004, or 22.5% of the overall market.

Regions Bank, which has wrapped 143 issues with a par value of $3.16 billion since 2004, was downgraded to A-minus from A-plus and A-2 from A-1, losing its “first tier” status under SEC Rule 2a-7. Moody’s Investors Service dropped Regions short-term rating to P-2 in May.

Municipal Market Advisors managing director Matt Fabian said Standard & Poor’s action on the banks was “not the catastrophe it could have been” for the variable-rate market as “there is enough demand out there for floaters, even split ratings, that it was a modest pressure only.” Most of the banks have ratings that still would qualify for purchase by money funds under Rule 2a-7, and the “more severely downgraded likely weren’t being owned by 2a7 funds in any event,” Fabian wrote in an e-mail.

The SIFMA swap index continues to sit near all-time lows as money funds remain starved for quality paper.  The index June 10 registered at 0.36%, two basis points up from a week earlier, but still well below historical averages.

Alpine Funds senior portfolio manager Steve Shachat said the downgrades will impact each money fund differently, depending on their investment parameters.

“Certainly some of the recent downgrades take the choice from some of the funds because they’ll have no choice,” Shachat said, referring to Rule 2a-7. “But everybody has a certain threshold and this just exacerbates it. It’s just a function of how much risk you’re willing to take on. And what we’ve seen over the last six months is funds have been pretty cautious with their investment style and these recent downgrades don’t help the situation.”

Standard & Poor’s said its banking sector analysis now includes a number of key factors, including that the “industry is now in transition and will likely undergo material structural changes” with stress tests “pointing to more pain in the future.” The agency also said it doesn’t view regional banks as being systemically important and that losses in loan portfolios “should increase, but recent capital rebuilding should help banks defray these losses.”

Standard & Poor’s said U.S banks counterparty credit ratings have fallen an average of two notches, to BBB-plus from A, as a result of downgrades since mid-2007.  It said it could it could raise the ratings on certain banks depending on how they manage the transition period.

“We believe some firms may be better able to weather the risks ahead than others,” Quintanilla said. “In the long term, we could foresee ourselves raising ratings if lower earnings and reduce risk are companied by stronger risk-adjusted capital and effective governance.”

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