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TBTF banks downgraded by Moody’s

By Claes Bell ·
Wednesday, September 21, 2011
Posted: 4 pm ET

Since Dodd-Frank took effect, being a "Too Big to Fail" bank isn't quite what it used to be, I guess. From Shannon Bond at the Financial Times:

Moody's downgraded the credit ratings of Bank of America, Citigroup and Wells Fargo, three of the biggest US banks, over concerns that the US government would be less likely to rescue the lenders if they faced failure.

"Moody's believes that the government is likely to continue to provide some level of support to systemically important financial institutions. However, it is also more likely now than during the financial crisis to allow a large bank to fail should it become financially troubled, as the risks of contagion become less acute," the ratings agency wrote on Wednesday.

This may sound like a bad thing, and it is, at least for investors, bondholders and depositors in excess of FDIC limits at those institutions. But it's actually a good thing from the standpoint of U.S. taxpayers.

For years now, we've been providing investors and bondholders in the country's biggest banks with a de facto insurance policy against losses. While it wasn't explicitly stated by regulators, everyone knew that, should a big enough bank ever get close to failing, the U.S. government would step in to bail them out. The economic consequences of the failure of a systemically important institution, and the complexity of the subsequent bankruptcy, were just too dangerous to shut them down the way they would a smaller bank.

This isn't theoretical; it happened during the financial crisis, when the U.S. government bailed out major U.S. banks through TARP and other programs. The structure of Dodd-Frank aims to replace that de facto system with a structured winding-down process, sometimes referred to as "living wills," for systemically important banks that would be managed by the FDIC.

Of course, such a process would be terrible for the aforementioned stock- and bondholders in those companies, as well as those holding deposits beyond the FDIC limit of $250,000. The former would largely be wiped out, and the latter would have to get in line with everyone else to get paid, just as they would in any other bank failure.

But not everyone bought into the idea that the government would actually follow through on the plan when push came to shove. One high-profile critic, Neil Barofsky, said that Dodd-Frank had "clearly failed" to convince the markets that the government was serious about winding down mammoth institutions.

But this downgrade from Moody's seems to reflect a belief within the ratings agencies that it will, and that's a good thing. Big banks simply should be getting a cushier deal on credit than their smaller brethren simply because of an implicit guarantee from the government.

Aside from preventing future bailouts and the massive public expenditures, one of the big goals of Dodd-Frank was to reintroduce moral hazard for TBTF institutions. This ratings downgrade from Moody's may be a sign that it's working.

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