Vikrant Sitani's  Instablog

Bank's balance sheets are very opaque. In the absence of information about the portfolio, various metrics are used to determine the credit risk of the banks. One of them is the Tier 1 common ratio. The higher the ratio, safer is the bank. The higher ratio implies that bank has higher common equity capital buffer on its balance sheet to absorb the unexpected losses in the future. Looking at the current ratio (see below), Goldman Sachs and Morgan Stanley has ratio higher than most of the other banks. This implies that these banks are safer than other banks like JPM and Well Fargo. FED recently completed its Annual Stress test and it published the projected ratios under hypothetical adverse scenario in Q4 of 2014. However looking at these, the ratio of Goldman and Morgan Stanley's CDS drops lower than most of its peer banks. It is due to the type of assets that it held on its balance sheet. They have assets, which are more likely to sustain losses under the hypothetical adverse scenario.

In the following table, there is current spreads based on 5 yr CDS. In the opinion of CDS market, JPMorgan is significantly safer than Citibank, even though Citi's projected capital is higher than JPM. There is some variation as to what markets consider safe banks and what FED considers safe. This gives some opportunity to investors to trade in securities of one bank with another depending on how much weight an investor wants to give to FED's projected results.

Morgan and Goldman has much higher CDS than other banks, as market is saying that in future these banks will have lower Tier 1 common ratio.

Now, if one has the view the hypothetical adverse scenario is unlikely to happen, one can earn higher spread by buying bonds of Goldman Sachs, than JPM.

Source: Federal Stress Test data and Bloomberg