No Lehman Moments as Biggest Banks Deemed Too Big to Fail


There may be no government action more universally reviled in the U.S. than bank bailouts. Republicans and Democrats, financial industry lobbyists and watchdogs, Wall Street executives and President Barack Obama say taxpayers should never again rescue a failing bank.

To make sure a future crisis won’t force governments to intervene, international regulators are requiring the biggest banks to borrow less. Three years ago, U.S. lawmakers passed the Dodd-Frank Wall Street Reform and Consumer Protection Act -- with provisions to liquidate a collapsing financial institution and end the perception that some banks are too big to fail.

“Because of this reform, the American people will never again be asked to foot the bill for Wall Street’s mistakes,” Obama said on July 15, 2010. “There will be no more taxpayer-funded bailouts -- period.”

Investors, it turns out, don’t believe that, Bloomberg Markets magazine will report in its June issue. The people who lend money to the largest banks are betting that Uncle Sam will toss a lifeline to a giant should it stumble, according to a study by Deniz Anginer, a World Bank financial economist.

Bondholders who lend money to the six biggest U.S. banks are so convinced the government will bail out these institutions that they are willing to accept lower returns -- a marketplace subsidy worth $82 billion from 2009 through 2011, Anginer calculates.

$102 Billion

These six banks -- Bank of America Corp., Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley and Wells Fargo & Co. -- have also benefited from tax breaks and Federal Reserve largesse since the end of 2008 in the form of additional income from the central bank’s mortgage-bond purchases and the interest it pays for bank deposits.

All told, the financial advantages for the six biggest banks since the start of 2009 amounted to at least $102 billion, according to data compiled by Bloomberg.

“The big banks have the taxpayers standing behind them, so people who lend them money know they’ll be paid back,” says Cornelius Hurley, director of the Center for Finance Law & Policy at Boston University and former assistant general counsel at the Fed. “That too big to fail no longer exists is not credible.”

The firms that rate the creditworthiness of banks say the likelihood of a government rescue hasn’t gone away. Because of the implicit promise of bailouts, Moody’s Investors Service, the second-largest U.S. ratings company, has boosted the scores for the six banks. Each increase in credit grade makes borrowing less expensive.

Junk Risk

In a March 27 report, Moody’s displays a bar chart of its credit ratings for the banks in blue. In green bars, it shows Goldman Sachs and Wells Fargo would be rated two grades lower if the taxpayer backstop didn’t exist. Moody’s boosted Morgan Stanley’s score by two grades for the same reason, even though it had downgraded that bank in June 2012.

The scores for Bank of America, Citigroup and JPMorgan are three grades lower in the green bars.

Debt sold by the holding companies of Bank of America and Citigroup, the second- and third-biggest U.S. banks by assets, would fall to junk status without the implicit government guarantee, Moody’s Senior Vice President David Fanger says.

“They have a high probability of government support,” Fanger says.

‘Not Solved’

No less an authority than Fed Chairman Ben S. Bernanke says the biggest banks are still being rewarded because of their size: He used the word “subsidy” at a March 20 press conference. Having banks that are too big to be allowed to collapse remains a major issue, he said.

“It is not solved and gone,” Bernanke said. “It’s still here.”

Some investors say the federal backstop is a good thing.

“The biggest mistake that could be made would be to allow significant banking institutions to fail,” says Gabriel Borenstein, managing director of New York-based Enclave Capital LLC.

“The sequential events that would follow, largely driven by psychology, cannot be quantified,” Borenstein says. “Another Lehman Brothers collapse could trigger a potential implosion.” Lehman Brothers Holdings Inc. was the third-largest U.S. investment bank in September 2008 when its bankruptcy filing deepened the longest recession since the 1930s.

20 Years

Buyers of big-bank debt have been counting on government aid for at least 20 years, says Anginer, who’s also a professor at Virginia Polytechnic Institute and State University’s Pamplin College of Business in Falls Church.

He’s researched the issue with Viral Acharya, a finance professor at New York University’s Stern School of Business, and Joseph Warburton, a law and finance professor at Syracuse University. They collected more than 84,000 data points for 567 financial firms going back to 1990.

The researchers looked specifically at the difference between what the banks paid creditors for borrowing money and what investors earned from owning U.S. government debt. They subtracted that number from the same measurement for smaller banks and, taking into account differences in risk unrelated to bank size, determined the value of the implicit government subsidy.

The discount for the top 10 percent of banks from 1990 to 2010 was worth, on average, $20 billion annually. In 2009, as lending dried up and the government aided the big banks, the borrowing discount ballooned to about $100 billion.

‘Well, No’

Anginer says he decided to do the research after hearing bankers and Treasury officials say the 2008 bailouts were a success.

“People at the banks were saying, ‘We paid our money back with interest; everything’s great,’” Anginer says. “Well no, it’s not. There are other costs we should be looking at.”

The reason investors accept lower returns on bonds issued by the largest banks isn’t because those firms are more careful than their smaller competitors. It’s because they believe the government will prop up the big banks if they falter.

The researchers reached that conclusion by isolating a series of risk measurements that affect the cost of debt. One is called maturity mismatch -- how much the banks had been able to borrow short term, for which rates are usually lower, while lending long term. That practice helped doom Lehman Brothers when short-term loans dried up in 2008.

Research Methods

They also applied a calculation created by Nobel Prize-winning economist Robert Merton known as distance to default, which is usually used to predict bankruptcy. The biggest banks behaved no more safely than smaller banks, the researchers found.

Anginer did bank-by-bank computations of the discounts at the request of Bloomberg Markets. He subtracted the customer deposits of each firm from the interest-bearing liabilities.

The big banks’ borrowing advantage swelled to $37.2 billion in 2009 after Congress authorized spending $700 billion on bank bailouts. The discount decreased to $29.9 billion in 2010 as the economy improved and to $14.6 billion in 2011, Anginer found.

The decline doesn’t mean the subsidy will disappear anytime soon, says Edward Marrinan, co-head of market strategy at RBS Securities Inc. in Stamford, Connecticut. The discount will probably continue to fall as investors become more confident that the government will allow big banks to fail, Marrinan says.

“We’re in the middle of a natural process of moving from implicit support to where the banks will be at arm’s length from taxpayers,” he says. “That process might take a long time.”

‘Don’t Believe’

Wells Fargo Chief Financial Officer Timothy Sloan says too big to fail is already over. “I don’t believe there’s a government backstop, and I disagree that there’s a benefit,” he says. “We don’t think we should be bailed out. If we do a very poor job, we should be fired.”

Additional costs the largest banks bear must be taken into account when tallying the advantages they enjoy over small ones, says Mark Kornblau, a spokesman for New York-based JPMorgan.

“Each year, we spend billions of dollars on people, systems and technology related to regulatory requirements, and we have higher capital and liquidity standards,” he says. “Those and a range of other factors add up to make claims of a supposed funding advantage less credible.”

On a global level, big banks are treated differently because of their size. The Financial Stability Board, an international oversight group created by the Group of 20 countries, has deemed the big six systemically important financial institutions, or SIFIs.

Extra Capital

These large banks must fund themselves with as much as $2.50 in extra capital for each $100 in assets. They also must have the $7 per $100 required for all banks. The so-called SIFI buffers need to be in place by 2019. U.S. banks are already accumulating the extra equity.

“While size can provide certain benefits, including diversification and economies of scale, it also attracts higher capital charges, which add to costs,” says Michael DuVally, a spokesman for New York-based Goldman Sachs.

Spokesmen for Charlotte, North Carolina-based Bank of America and Citigroup and Morgan Stanley, both based in New York, declined to comment.

Lenders have also benefited from the Fed’s policy of buying mortgage bonds through quantitative easing. Wells Fargo, which originates almost one-third of U.S. home loans, gained $2.07 billion from that program, according to data compiled by Bloomberg. Bank of America received $1.16 billion, followed by JPMorgan, with $767 million, and Citigroup, with $332 million.

William Dudley

Quantitative easing helped push the average 30-year-mortgage interest rate to a record low of 3.31 percent in November. William C. Dudley, president of the Federal Reserve Bank of New York, says the central bank wanted to drive it even lower.

Lenders increased the difference between the rate they charge mortgage borrowers and the interest they pay to investors who buy the mortgage bonds. For years, banks added 50 basis points, according to the New York Fed. In December, the difference widened to 150 basis points. (A basis point is 0.01 percentage point.)

“This suggests that originator profits may have increased,” Dudley said at a public meeting in December 2012.

Too big to fail will remain a political issue. In April, two senators -- Democrat Sherrod Brown of Ohio and Republican David Vitter of Louisiana -- introduced legislation requiring the biggest banks to fund themselves with less borrowed money. They also asked the Government Accountability Office to calculate the advantages of being systemically important.

The GAO report will be published next year.

As the U.S. economy has improved, the dollar amounts of advantages enjoyed by the six biggest banks have decreased. Yet too big to fail persists, a legacy of the 2008 financial crisis and a reminder of the bailouts so many people love to hate.

With assistance from Sharon L. Lynch in New York. Editors: Jonathan Neumann, John Voskuhl

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