Two important processes that drive competitive dynamics in the banking sector get overlooked quite a bit, Gresham's law and Moral Hazard.
Gresham's law states that good money gets pushed out by bad in banking, just like in insurance. Banking and insurance are commodity games. When risk adjusted rates become un-economical due to competitive pressures a participant has one of two choices, sit on the sidelines or drop risk standards. Few like to sit on the sidelines and many who do find their boards don't and so they dance taking significant risks.
Over time this process means that in a particular time the bad money crowds out the good money in terms of market share. This is Gresham's law an important process to consider and be aware of. The opposite effect occurs in goods and services markets where typically the better value via pricing power pushes out the weaker offerings to the benefit of consumer and offerer alike.
The other important behavioral factor that drives a competitive process in banking is moral hazard, which effectively encourages individuals to take on too much risk, knowing they will be bailed out. Moral hazard, means you can do whatever you want, because someone will always bail you out.
So here is the interesting question. Gresham's has worked over the last decade to leave the US with some dangerously risk banking firms in terms of leverage and on an tangible common equity basis and from a loan portfolio perspective.
If one views Too Big to Fail to be real and one believes that means saving the equity holders in a bank at all cost, then this belief should be reflected in options prices. If the FED is going to bail a bank's equity holders then there should be an effective floor on the price of those shares.
For example if you think that JPM morgan would be wiped out with global catastrophic effects if equity sank below $20 per share, then maybe you think the Federal reserve would step and save them. In such a case, selling puts at $20 or below is risk free money. Here are two questions for the reader which I don't have answers to but which are interesting conjecturs.
- Are JPM and BAC equity holders protected?
- If JPM and BAC equity holders are protected at what levels?
Here are some very sloppy graphs with options curves using interpolations from the price points. I don't advise play poker against central banks or writing puts to test the limits. Where would you place the line in the sand for equity on BAC, JPM or Citi (C)?
The Excel file is here.WheresTheFed
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.