Recently, there has been a lot of press about the rating agencies and how they incorporate "too big to fail" status into their bank ratings. One rating agency gives some banks as much five notches of uplift for TBTF. With the possibility that further rulemaking associated with the Dodd-Frank financial reform bill will eliminate TBTF, the rating agencies are preparing the market for the possibility of massive downgrades in the banking sector.
For Morningstar, the possibility of certain banks losing their TBTF status would have little effect. We generally give a one-notch upgrade from our model-driven rating for the effects of TBTF. We have always believed that businesses should be rated on their merits, rather than as extensions of the federal government. In our view, if the large banks truly possess long-term TBTF status, then they should be rated and trade almost in line with US Treasuries. We were also concerned that political backlash against rescues of financial firms could lead to a lack of protection in the future, regardless of the economic consequences. We therefore incorporate only a one-notch rating upgrade for the largest banks, acknowledging the possibility of assistance without basing our ratings on political analysis.
Without TBTF status, it appears that rating agencies would rate big banks like Citibank (C) and Bank of America (BAC) in the mid to high BBB area, down from their low AA/high A current ratings. Five-year credit default swaps on Citi and B of A are about 140 and 160 basis points, respectively. It is clear to us that the market already discounts the TBTF status, and while we expect some increase in CDS should the TBTF status be more explicitly removed, we doubt that it would have a meaningful impact. Counteracting the loss of TBTF is the overall improvement in the health of the big banks. Recently, we upgraded Citi from BBB+ to A- as the bank has raised its Tier 1 common ratio more than 200 basis points in the past year to 11.3%. We also placed Citi bonds on our investment-grade Best Ideas list. We believe bond investors should evaluate the banks on their stand-alone merits and invest accordingly, as shaking hands with the government becomes far more risky as free-market advocates gain sway in Congress. But even on that basis, bank bonds still trade wide to the rest of the market and bond investors who do their homework will benefit from the juicy yields.
