JPMorgan's $10 Billion Subsidy

The value of being too big to fail
Photograph by Andrew Harrer/Bloomberg

In  late June, Jamie Dimon told a Senate committee that no taxpayer money was “impacted” by this spring’s trading losses at JPMorgan Chase. Dimon, the bank’s CEO, meant that no one at the Treasury Department had to write a check to save the bank. He’s right, and likely to continue to be right, even after the revelation that the bank’s trading losses might run as high as $9 billion. But checks are not the only thing of value the federal government can offer a bank.

According to Reuters, on June 28 Richard Fisher, president of the Dallas Federal Reserve, said that the markets assume that larger banks are too big to let fail. That much we knew. He also pointed out that this assumption lowers borrowing costs for those banks, which he called an “unfair subsidy.” He didn’t name names, but we can. Even better, we can give you an idea of the size of this subsidy. By one estimate, between 2007 and 2010, simply being too big to fail saved America’s biggest banks a combined $120 billion. Citigroup saved the most, coming in at just over $50 billion. And even with its fortress balance sheet, JPMorgan saved just under $10 billion thanks to its size and importance.

The estimate comes from a paper Frederic Schweikhard and Zoe Tsesmelidakis presented in late May to an NYU Stern School of Business conference on credit risk. The pair, both PhD candidates at Goethe University Frankfurt, relied on a time-proven tool of finance – the Merton model of pricing corporate debt–to come up with their estimate.

The Merton model is tricky to understand. Luckily Robert Merton, a Nobel laureate now at the MIT Sloan School of Management, answered the phone in Cambridge to help explain it. “Pick up two pieces of paper,” he said, “are you doing it?” I was doing it. “Now,” he continued, “label one ‘corporate bond’ and the other ‘full faith and credit of the United States Treasury.’” He told me to put them together, and asked me what I had. It looked like two slips of paper stacked together. “That’s risk-free debt,” he said, “you’re gonna get paid no matter what.” The price of every loan, he explained, consists of two pieces: the inconvenience of parting with your money for as long as the borrower needs it , and the risk that the borrower will default before repaying you–which, in the case of the big banks, is eliminated by the Treasury’s implicit guarantee.  “Those are different activities. One is the time value of money, and the other is insurance,” he said.

In 1974, Merton published a model to price the slip of paper labeled “guarantee.” He treated it like an insurance policy on the company’s assets. The lender gets extra money for the guarantee from the borrower–like an insurance premium. If a catastrophe happens, the lender loses some or all of his principal–like an insurance payout.  (If you’re a financier, you also know this as a put option, an insight that Merton used to do his math. But if you are a financier, you can also skip ahead.) Merton’s model wasn’t widely used in practice until a rash of corporate defaults in the late 1990s. To have a theoretical method adopted for practical use, says Merton, “I would say the three most important factors are need, need and need.” Investors suddenly needed to understand how to protect themselves from these defaults.

Schweikhard and Tsesmelidakis have now applied Merton’s insight to the risk of bank default. A credit default swap, they reasoned, is also just an insurance policy. Their paper takes stock prices of financial firms from 2002 to 2010 and uses Merton’s model to derive the theoretical prices of credit default swaps on those firms–excluding any effect of the government’s backing–for a fictional swap holder. They then compared that price to the actual prices in the market, and discovered a varying difference between the two, which they called “the wedge.”

The wedge shows that, in times of crisis, actual CDS prices are lower than theoretical CDS prices derived from the bank’s stock values. Stockholders of large banks know that, after a default, the values of their holdings will decline no matter what. But debt holders of those same firms know that a bailout might protect their assets. And they seem to expect one. For American financial firms the wedge – the difference in confidence between stockholders and debt holders – begins to spread in May of 2007. Right after the collapse of Lehman Brothers, it briefly disappears. For a moment, no one expected a bailout. Then the wedge yawns back open, undisturbed by the passage of the Dodd Frank Act, which promises an end to bailouts. The wedge does not close again until the relative stability of the fall of 2011 and the spring of 2012. And it begins to widen, again, in early May of this year, with more bad news from Greece.

Dodd Frank may promise an end to bailouts. But the market seems to know you can wake up a Congressman in the middle of the night and tell him the world is about to end. And this knowledge is valuable even to a company like JPMorgan, which never needed a bailout. If you accept Merton’s logic and Schweikhard-Tsesmelidakis’s data, since 2007 the United States has given away for free an insurance policy that would have cost JPMorgan dearly on the market. And with that free insurance policy, the bank saved a lot of money.

The paper looks at bank bond issues between 2007 and 2010, and estimates the amount that each bank saved in lower financing costs, given the market’s assumption of a credit guarantee from the United States government. This is how Schweikhard and Tsesmelidakis arrived at their savings tallies, bank by bank – again, a combined $120 billion. And this was only through 2010.

Jamie Dimon is right. No one wrote him a check, either during the financial crisis or after this spring’s trading losses. But somehow taxpayers managed to give him $10 billion anyway.

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