Too Big to Fail Discounted as Moody’s Evaluates: Credit Markets
U.S. lawmakers are making progress convincing derivatives traders that taxpayers won’t bail out the biggest banks if another financial crisis erupts.
Of seven U.S. banks that Moody’s Investors Service says have higher ratings because of an assumed government backstop, credit-default swaps on five of them, including Goldman Sachs Group Inc. (GS) and JPMorgan Chase & Co. (JPM), trade as if they’re ranked as many as two steps lower, data from Moody’s Analytics show. The rankings company plans to update those assumptions by year- end, leading bank analysts at UBS AG to anticipate ratings cuts.
The Federal Deposit Insurance Corp. is working on a rescue blueprint that would impose losses on bank holding company creditors to recapitalize systemically important operating units facing collapse, Moody’s said in a March 27 report. Federal Reserve Chairman Ben S. Bernanke said last month the swaps market is indicating some probability of bank failure.
“The FDIC is determined to reduce too-big-to-fail risk,” said Edward Marrinan, a macro credit strategist at Stamford, Connecticut-based RBS Securities. While Moody’s is still determining whether to lower its ratings, “the market is already there, and gets that this is a significant development in how to assess the risk profile of banks,” he said.
Credit-default swaps linked to Goldman Sachs, JPMorgan, Citigroup Inc. (C), Morgan Stanley, Bank of America Corp. (BAC) and Wells Fargo & Co. (WFC), the six biggest U.S. bank holding companies, are trading an average of 25 basis points more than a benchmark index tied to U.S. companies, according to prices compiled by Bloomberg and CMA, a data provider owned by McGraw-Hill Cos.
While the gap has narrowed from a record 246 basis points at the peak of the financial crisis in 2008, it’s still 10 basis points more than the median of 15 since 2004, the data show.
Regulators and lawmakers including Fed Governor Daniel Tarullo, Dallas Fed President Richard Fisher and Senator Sherrod Brown, a Democrat from Ohio, are pushing for more steps to prevent the need for bailouts even with the central bank, wielding new powers under the 2010 Dodd-Frank Act, compelling the largest lenders to retain earnings and strengthen their buffers against losses.
That’s coincided with about 320,000 jobs culled from U.S. financial companies in the past five years as lenders seek to boost profit amid weak revenue growth. The six largest banks, which announced plans in the first quarter to eliminate about 21,000 positions even after the industry posted its best results since 2006, may provide more details about personnel starting this week when they report earnings from the period. JPMorgan and Wells Fargo are scheduled to report results April 12.
Elsewhere in credit markets, a gauge of U.S. corporate credit risk fell the most in six weeks after minutes of the Fed’s March policy meeting showed several members said the central bank should begin tapering its bond-buying program later this year and stop it by year-end.
The Markit CDX North American Investment Grade Index, a credit-swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, declined 2.6 basis points to a mid-price of 82 basis points at 11:57 a.m. in New York, the lowest since traders began moving positions into a new version of the index three weeks ago, Bloomberg prices show. The gauge declined as much as 2.9 basis points, the biggest intraday drop since Feb. 27, the data show.
The indexes typically fall as investor confidence in creditworthiness improves and rise as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Fed officials, who met before a Labor Department report last week showed payroll growth in March was the slowest in nine months, debated how and when to curtail asset purchases that have swollen its balance sheet to a record $3.22 trillion. The committee decided at the gathering to press on with $85 billion in monthly bond buying until the labor-market outlook has “improved substantially.”
“You have to take this with a really large grain of salt,” said John Herrmann, director of U.S. Rate Strategy at Mitsubishi UFJ Securities in New York, because the meeting was held before the March jobs report. That report showed “the economy doesn’t quite yet have the momentum to consistently grow near the Fed’s objectives” and an early tapering of Fed purchases is now “much less likely,” he said.
Bonds of New York-based Goldman Sachs are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.3 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Moody’s, which placed “negative outlooks” on the holding company ratings of eight systemically important U.S. lenders in June, said last month it’s reassessing grades that are as many as two levels higher because of implicit taxpayer backing.
“We do see holding company ratings as under pressure,” David Fanger, an analyst at Moody’s who helped author the March 27 report, said in a telephone interview. “The government is moving toward policies that would reduce the likelihood of taxpayer-funded bailouts in the future.”
The FDIC has made “considerable progress” by identifying obstacles to implement its so-called orderly liquidation authority, which gives the agency power to wind down, split up or sell off companies considered a potential systemic risk to U.S. financial stability, Moody’s said in the report.
Those challenges include coordinating with foreign regulators, ensuring holding companies have enough assets to recapitalize their operating units and detangling the interconnectedness of banks that threatens to spark contagion during a crisis.
International cooperation “continues to be the biggest obstacle,” David Knutson, a Chicago-based credit analyst at Legal & General Investment Management America, said in a telephone interview. “While it’s probably easy to take care of a mess in your own house, it’s really hard to clean it up in someone else’s.”
The FDIC expects to issue additional rules and policy statements this year, said Greg Hernandez, a spokesman for the agency. He declined to comment on credit-swaps trading levels.
Credit swaps “indicate some probability of failure” even if too-big-to-fail assumptions haven’t disappeared, Bernanke said at a March 20 news conference. The central bank is buying $85 billion of assets a month to support the U.S. economy after lending excesses helped inflate a housing bubble that triggered the worst recession since the Great Depression.
Contracts linked to JPMorgan, which has a holding company senior debt rating of A2 that Moody’s says benefits from two levels of presumed government support, imply a grade of Baa1. Goldman Sachs (GS), rated A3 at Moody’s, have swaps that imply Baa2, two levels above junk.
The banks included in the Moody’s review are Bank of New York Mellon Corp., State Street Corp., Wells Fargo, JPMorgan, Goldman Sachs, Morgan Stanley (MS), Citigroup and Bank of America.
Contracts linked to Citigroup and Bank of America imply a Baa2 rating for both firms, equivalent to their current Moody’s grades and two levels above their standalone credit assessments without potential bailout support. Swaps on State Street, whose rating doesn’t benefit from a potential bailout, aren’t actively quoted.
Citigroup and Bank of America are rated “extremely low on a relative basis” with Moody’s not recognizing “improvements in capital, earnings and risk management at both these institutions,” JPMorgan analysts led by Kabir Caprihan wrote in an April 1 report.
“Our base-case assumption is that there will be a one- notch reduction across the board” with “potential for future upgrades in the standalone credit ratings for Bank of America and Citigroup,” the analysts said.
UBS strategists led by Robert Smalley also expect Moody’s to cut its ratings by one level as the probability for state support diminishes, according to an April 2 report. That would leave creditors of the holding company more vulnerable to losses as regulators develop an alternative strategy.
“The swaps market is beginning to acknowledge that,” Smalley, based in New York, said in a telephone interview.
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