Prowling Bond Vigilantes Should Stress Out Big U.S. Banks

Banks are notoriously complex. But in one respect, they are pretty simple; like other companies, banks depend on access to a raw material to build products and need to purchase it at a price that allows them to generate a profit.

For banks, that raw material is money. Whether banks can persuade credit investors to provide it comes down to confidence and capital. And as the European crisis shows, doubts on either can mean suppliers charge too high a price or simply walk away.

That is worth remembering as the Federal Reserve prepares for another round of "stress tests" to determine whether some big U.S. firms can return capital to shareholders. The Fed last week said that it would require 31 banks to undergo tests early next year and that it will single out six firms—J.P. Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs Group and Morgan Stanley—for a separate exam that assumes a global credit crunch.

In doing so, the Fed will again grapple with the question of how much capital is enough. That is particularly tricky because the Fed wants banks to hold enough capital to absorb losses but also doesn't want to constrain lending and, thereby, economic growth. And the Fed faces an added dilemma. It has decided the economy is so fragile that extraordinary monetary-policy actions are appropriate and even more may be needed. That in itself argues against banks doing anything other than stockpiling capital.

For their part, banks argue that holding too much capital hampers credit creation. They also worry that holding more capital makes it tough to generate higher returns on equity, affecting valuations. As it is, the major U.S. banks have Tier 1 common ratios based on existing rules of between 8% and 11%, healthy levels.

Yet any doubt about capital sufficiency means banks can lose access to funding. That, too, can have adverse economic consequences. In a note Friday, analysts at Morgan Stanley argued that "bank funding is as big a brake on bank lending as bank capital." Banks that can't raise funds have to shrink their balance sheets.

So it is good the Fed's coming stress tests look stressful. In its worst-case scenarios, the Fed will ask banks to consider their capital buffers in the event unemployment hits 13% in early 2013, real gross domestic product shrinks almost 8% in the beginning of 2012, home prices fall another 20% between now and early 2014 and stock markets fall 50% over the next 12 months.

That strikes some as overkill. "The only adverse event the Fed left out is a direct asteroid strike on a major banking center," Karen Petrou of Federal Financial Analytics said in a report.

But the lack of investor confidence in banks justifies a harsh approach. Of the six biggest banks, none are trading above book value, and only Wells trades above tangible book. Given this, the Fed needs to be mindful of credit investors. Granted, the Fed has been able to print money without bond vigilantes exacting revenge. But the vigilantes are present in bank credit markets, as Europe's institutions know.



Even U.S. banks are feeling some heat. The price of insuring against default at the biggest institutions, for example, has jumped. Late last week, it cost about $474,000 to insure $10 million of Bank of America debt, compared with $157,000 in January, according to Markit. J.P. Morgan's 4.35% debt due August 2021, meanwhile, traded at a premium of about 2.79 percentage points to Treasurys last week, according to MarketAxess. That compared with a spread of about 1.7 percentage points at the end of August.

Clearly, the bond vigilantes are on the prowl. The Fed shouldn't do anything that spurs them to further action.

Source: http://online.wsj.com/article/SB10001424052970203764804577060581490016436.html