April 17 (Bloomberg) -- Forget tough talk about repaying government funds issued through the Troubled Asset Relief Program. To really prove they are fighting fit, banks and brokers need to show they can consistently tap debt markets without government backing.

That will be a truer test of whether they and the wider financial system are healing. It will also show, cheery first- quarter results aside, whether firms like Goldman Sachs Group Inc. and JPMorgan Chase & Co. are the top dogs they claim to be.

JPMorgan yesterday got a lap ahead in this race, with a $3 billion, 10-year debt issue that didn’t have government backing. That put it ahead of Goldman, which sold $2 billion in February without a government guarantee.

While these are welcome first steps, it is early days yet and more banks need to do the same. For months, Goldman, JPMorgan and other banks have depended on government guarantees to sell debt they use to fund their operations.

That backstop, provided by the Federal Deposit Insurance Corp., was put in place following last fall’s collapse of Lehman Brothers Holdings Inc. Since then, Goldman and JPMorgan, along with Morgan Stanley, Bank of America Corp., Citigroup Inc. and Wells Fargo & Co., have issued more than $160 billion in FDIC- guaranteed debt, according to Bloomberg data.

The FDIC program has been overshadowed by TARP funding and the government restrictions that came with it. JPMorgan Chief Executive Officer Jamie Dimon yesterday called the TARP a “scarlet letter” and said his bank could repay the $25 billion it received right away, if necessary.

More Than TARP

Yet the FDIC backing has in many ways proven more crucial to banks than the TARP funds. Even with TARP money shoring up bank equity, investors are doubtful that many banks have enough capital to weather losses spurred by the housing crisis and markets meltdown.

Banks kept functioning in spite of this, and in some cases staved off insolvency, largely because they were able to access debt markets due to the FDIC program.

This means debate over whether the Treasury Department should allow firms like Goldman and JPMorgan to repay TARP funds is a red herring. Until banks and brokers can issue debt without the help of the FDIC, they will essentially remain wards of the state.

“Paying down the TARP is kind of neither here nor there,” said Christopher Whalen, a managing director at bank research firm Institutional Risk Analytics. “If you have to have a government guarantee to fund yourself, capital doesn’t matter anymore.”

Debt Dependency

Tapping debt markets is especially important for Goldman and Morgan Stanley because both are still more reliant on such funding than traditional commercial banks. Those banks typically have large deposit bases that provide a good chunk of reliable money to fuel their lending operations.

That said, the bigger commercial banks also need debt markets, and the FDIC program was vital for providing funds that allowed them to continue lending in recent months, noted Jim Vogel, an analyst at FTN Financial.

Of course, accessing debt markets without FDIC backing will be tough for even the strongest banks and brokers. Only Goldman and JPMorgan have tried it so far this year, and for only small amounts. Through the FDIC program, meanwhile, Goldman has issued about $22 billion in debt since last November and JPMorgan almost $40 billion.

More Thawing

They and others may have more of a chance if credit markets continue to thaw. Some, though, like Citigroup, will likely find it impossible for some time, given balance-sheet woes that caused the government earlier this year to take a direct common equity stake in the bank.

And even if markets are receptive to non-guaranteed debt, it will cost more because investors would want higher yields to compensate for the greater risk involved.

That may cause some firms to think twice about giving up on the FDIC program too quickly. The cheaper FDIC funding, for example, helped fuel Goldman’s outsized, first-quarter trading revenue of $8.5 billion, research firm CreditSights noted in a report earlier this week.

During his firm’s conference call this week, Goldman Chief Financial Officer David Viniar said he would like to continue issuing unguaranteed debt, but only when markets “allow us to do that.”

If banks can cut the FDIC apron strings, there will be offsetting benefits. For starters, the more government support banks can shed, the less potential congressional interference.

A bank’s ability to work without the FDIC safety net may also become a sign of health that investors look for as they decide which banks will survive the crisis. That might become an important dividing line if Treasury refuses to let banks return TARP funds, for fear of stigmatizing those that are unable to do so.

Most importantly, debt-market self-sufficiency will signal that banks are no longer government-controlled utilities. That, rather than TARP payback talk, is something to shout about.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: April 17, 2009 00:01 EDT