Yesterday Moody's put the debt of four of the six big U.S. banks - GS, JPM, MS, and WFC - on review for downgrade, and the other two - C and BAC - on the amusing "review direction uncertain,"1 because Moody's is becoming increasingly convinced that, if those banks blew up, the government would not bail out their holding company unsecured debt. Not entirely convinced - it's just "consider[ing] reducing its government (or systemic) support assumptions to reflect the impact of US bank resolution policies" - but more convinced, anyway. More convinced than it was in March, when it announced "that it would reassess its support assumptions for bank holding companies in the US and that it would consider whether to revise these assumptions by the end of the year."
It's a boring cliché at this point to point out that credit ratings are a lagging-to-contrarian indicator, but still:
Moody’s said March 27 it would reconsider its assumptions of government support for the largest lenders ....
Relative yields on bank bonds have narrowed 8 basis points this year to 159 basis points, or 1.59 percentage points more than Treasuries, as of yesterday, according to the Bank of America Merrill Lynch U.S. Banking Index. That compares with an increase of 9 basis points for industrial bonds that had an average spread of 153.
Credit-default swaps linked to the six biggest U.S. banks also signal improved credit quality. The contracts, which pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt, cost an average 112 basis points at 5:44 p.m. yesterday in New York from 129 at year-end, according to prices compiled by Bloomberg.
Good time for a downgrade then! If you're keeping score at home, the decreasing likelihood of government support for too-big-to-fail banks coincides with:
- their credit ratings getting worse, and
- their credit getting better.
As an exercise for the etc., how would you use that information to calibrate your ratings-agency-uplift-based model of the too-big-to-fail subsidy?2 How, if at all, would you use it to evaluate whether Moody's has any particular inside information into the actual likelihood of government support for banks?
One could I suppose have less childish thoughts. One might be that would not be a wholesale victory for banking regulators if Moody's slashes a bunch of ratings on huge giant systemically important banks because of the withdrawal of prospective government support. Like oh sure it might be preferable for the government not to bail out the banks if they go bust, but it'd be even more preferable for the government to meaningfully reduce the risk of the banks going bust. The idea is that the withdrawn government support should be replaced with safer banking or thicker capital cushions or whatever rather than just with nothing.
And to be fair Moody's thinks it sort of has been. Those "review direction uncertain" actions on BofA and Citi are due to "the potentially offsetting influence of improvements in the standalone credit strength of their main operating subsidiaries, the ratings on which were simultaneously placed on review for upgrade." And even in the review for downgrade cases there's some good news:
As US bank resolution policies continue to evolve, Moody's will assess the opposing forces that may have an impact on bondholders at the holding company level should a bank become financially distressed. The first is a lower level of systemic support that could result in a higher probability of default. The second is the potential for a more orderly workout and a required minimum level of holding company debt that may well limit losses in the event of a default.
Before, your holding company debt sat above an abyss but was held up by what Moody's wildly guessed was a pretty good chance of government bailout. If things went pear-shaped and there was no bailout, things would be very very bad, but how likely was that?, asked Moody's, I suppose. Now that bailout is less likely, they'll wildly guess, but the abyss has been filled in with a bunch of new bail-in-able debt and is now sort of a gentle valley. You can see why people whose job is investing in bank debt, rather than critiquing it, might prefer the gentle valley, even with reduced chances of government support, to the uncertain bridge over the abyss.
The best rated of those banks, at A2 for holdco senior debt, are JPM and WFC, with GAAP leverage of around 12x and 9x respectively,3 and with a certain amount of squishiness pertaining to asset valuation and operational risk. If you want to turn your mind to the abyss, it will give you plenty to think about. And Moody's guess that the government will probably bail you out if anything goes wrong may not be completely comforting. An explicit plan from the government, even one that involves you taking losses instead of being bailed out, might be worth more than a more favorable bailout that exists mainly in Moody's expectations.
1."We know something is happening! BUT WHAT IS IT?"
2.If you answered "I would change the sign in the model to reflect the assumption that better credit ratings make banks' debt more expensive," who could blame you? Then would you throw out the model? Or what?