Too-big-to-fail. Those four words pretty much sum up everything you need to know about the U.S. banking system. And, since 2008, the system became even more concentrated after Wachovia, Countrywide Financial, Merrill Lynch, Washington Mutual, and Bear Stearns were swallowed up by larger counterparts. Fast forward to today, and once again we see equity prices of the giant banks under pressure.
Goldman Sachs (GS) and JPMorgan Chase’s (JPM) stocks are down over 24% in the past month alone. Bank of America (BAC), Citigroup (C), and Morgan Stanley’s (MS) stocks are down over 30% in a month. Meanwhile, over the same time period, State Street (STT), Wells Fargo (WFC), and The Bank of New York Mellon’s (BK) stocks are down only 14.2%, 14.5%, and 21.5% respectively.
Should we be “buying these stocks hand over fist,” as Dick Bove recently said in a November 18, 2011 CNBC interview, regarding the largest U.S. banks? I prefer to leave those equities alone, letting others debate their valuations. I don’t know what to believe when looking at the balance sheets of the largest U.S. banks and therefore can’t figure out how to appropriately value the equity. The debt, however, is a different story.
In an era of too-big-to-fail, credit analysis changes. Major rating agencies like Moody’s (MCO) will still issue in-depth reports on too-big-to-fail institutions, and the reports will be filled with all sorts of details and analysis supporting the ratings decisions. However, in an era of too-big-to-fail, credit analysis actually has less to do with financial metrics and more to do with politics. Therefore, analyzing credit quality in today’s financial reality has more to do with forming an opinion of the political climate than anything else.
Unfortunately, this makes the analysis more subjective. Hopefully, this will not always be case, and as facts change, investors can change the approach. Nevertheless, the most important thing a purchaser of debt needs to figure out is whether his or her principal will ever be returned. And what 2008 taught the world is that when too-big-to fail banks get into serious trouble, governments get involved.
With this in mind, in today’s United States, a more relevant credit analysis on American systemically important financial institutions JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, State Street, The Bank of New York Mellon, and Morgan Stanley might look something like this:
First, an investor should decide whether a bank in question will be bailed out or file for bankruptcy, if that bank ever finds itself on the brink of failure. This will depend on a number of things, such as the makeup of Congress, which party controls the White House, and the financial belief system of the then current Secretary of the Treasury and Fed Chairman. Using recent history as a guide, the public’s mood towards the banking system matters less than the Treasury Secretary or Fed Chairman’s ability to scare the daylights out of congressional leaders. When considering all the above, if you believe bankruptcy is a strong possibility, don’t touch the bonds. If the answer is bailout, proceed to the next set of questions.
Second, if a bank you are interested in will be bailed out, how will the bailout be structured? Will the banks be nationalized, resulting in the entire capital structure either being wiped out or suffering severe write-downs? Again, using recent history as a guide, nationalizing American too-big-to-fail banks doesn’t seem like a path the current mix of politicians would be willing to take. The Europeans, on the other hand, appear more likely to lean towards nationalizing banks, and therefore, I am not interested in discussing debt purchases of banks from that part of the world. In the United States, we appear more interested in bailouts and protecting shareholders. So, under bailout scenarios in which shareholders won’t take a hit, bondholders, at least in the parent companies, should be safe as well.
However, if an assertive public is able to convince politicians to flex some muscles, perhaps a creative scheme could be created whereby no nationalization or traditional bankruptcy takes place, yet parts of the capital structure still take a hit. Under this scenario, an investor would have to decide the likelihood of such a scheme negatively affecting the subordinated debt (junior debt). If the decision is that junior debt will take a hit, the investor would have to decide whether investing in that part of the capital structure is still worth the risk, or whether unsubordinated debt (senior debt) is the way to go. For even if junior debt ultimately is punished, it might be possible to hold that debt for a period of time and eventually hedge the bonds so that when the write-downs occur, the principal is still protected.
Once it is determined that an investment in the debt of an American systemically important financial institution is acceptable (if this is the outcome), one more final consideration must be made. In the event of a full-fledged banking crisis such as in 2008, the authorities might decide that in order to give credence to any prior legislation claiming to end too-big-to-fail, one or two sacrificial lambs must be allowed. Perhaps, under this scenario, a large bank not labeled systemically important is chosen, and the others are bailed out in the name of saving the financial system. However, keep in mind that eight American banks are on the list of 29 systemically important financial institutions, also known as “too-big-to-fail” banks. If you are nervous about a sacrificial lamb coming from this list in the future, you would obviously want to avoid purchasing the bonds of that particular bank.
While there clearly might be other details to consider when analyzing the political climate’s ultimate effect on the bonds of a struggling too-big-to-fail institution, the aforementioned paragraphs should provide a framework for doing so. In today’s financial world, credit analysis of too-big-to-fail banks in the United States has changed from earlier days. While performing an analysis of the equity still involves delving into the financial metrics of the banks, analyzing the debt is different. Political considerations now take the cake.
If after performing the too-big-to-fail credit analysis, you are interested in purchasing the bonds of American systemically important financial institutions, please read my next article, “17 Too Big To Fail Senior Bonds,” which provides a list of senior debt from various American too-big-to-fail banks.