Too Big To Fail: Market Says Some Banks Only Slightly More Likely To Default Than U.S. Treasury

Has the government’s implicit policy of rescuing “too big to fail” banks ended? Not according to the market.

As Peter Boone and Simon Johnson slyly note in this post, the market does not believe that the government has made — or will make — any significant changes to its approach to dealing with ailing mega-banks.

In their post, Boone and Johnson consider whether or not Ben Bernanke should be reconfirmed for a second term as head of the Federal Reserve. In defending his tenure, Bernanke has pointed out that the government will not continue a policy of “too big to fail” and will find an orderly way to unwind failed banks. (To be fair, this is one of the key components of pending financial reform bills.)

Johnson, however, argues that the market doesn’t believe Bernanke. The implied probability of Bank Of America defaulting on its credit default swaps is only slightly higher than the probability of the U.S. treasury defaulting, Johnson notes.

Here’s Johnson:

The market view is that Bank of America, despite all its problems and a risky balance sheet, is only slightly more likely to default than is the United States government (which, despite recent criticism, is still one of the most reliable borrowers in the world). The market view for all other major United States banks is essentially the same.

In other words, Mr. Bernanke’s crucial audiences — in financial markets — do not find him credible on the central issue of the day, presumably because he is unwilling to condone measures that would ensure today’s huge banks become “small enough to fail.”

If potential creditors do not fear losses, they will provide funds on easy terms to our big banks and we will re-run some version of our previous bubble. This is how our financial system works.

Investors use credit default swaps (CDS) as a kind of insurance against a certain events occurring. What all this means, essentially, is that investors believe that Bank of America is almost as stable as the American government.

Earlier this month, at the Wall Street Journal Matt Phillips noted that the CDS spreads for the nation’s largest banks has returned to those halcyon pre-crisis levels, which has drawn the ire of the Congressional TARP panel:

Since [Sept. 2008], Morgan Stanley, Bank of America and Citigroup [CDS prices] have fallen back into a range roughly in line with where they were before the crisis struck. AIG, on the other hand, remains persistently elevated, signaling that the market remains skeptical on the outlook for the troubled, government-controlled insurance giant.

Interestingly, the TARP panel threw this tidbit into their analysis of exactly why the CDS spreads have contracted for the institutions that were bailed out by the government. “It is unclear the extent to which this decline in CDS spreads is due to confidence in major banks’ stand-alone creditworthiness and to what degree this decline reflects CDS market confidence in implicit government guarantees of large banks.

The too-big-too-fail issue is alive and well. And it likely will be for a while…”

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Read more: Too Big to Fail, Cds, Bank of America, Credit Default Spreads, Federal Reserve, Banks, Ben Bernanke, Simon Johnson, CDS Spreads BofA, Business News


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