Goldman Sachs says that the commonly held view that TBTF banks can borrow cheaply used to be a little bit correct, became very correct during the financial crisis, and now is totally incorrect.
The Wall Street firm recently put out a paper with the mild title of "Measuring the TBTF effect on bond pricing." It argues that the commonly-held view that TBTF banks can borrow cheaply because bond investors expect the government will support them used to be a little bit correct. Then it became very correct during the financial crisis. But now is totally incorrect.
The study argues that that six banks with more than $500 billion in assets paid interest rates on their bonds that were an average six basis-points lower than smaller banks from 1999 to mid-2007. When the financial crisis struck, the funding advantage grew far wider. But beginning in 2011, the funding difference reversed, with the biggest banks now paying an average of 10 basis points more than smaller banks.
"This undermines the notion that government support drives a TBTF funding advantage," the report says.
Well, not exactly.
The Goldman researchers are practicing a bit of sleight-of-hand here. The argument about TBTF funding has never been predicated on the absolute funding levels of banks or the funding of big banks relative to small banks. Rather, it's that the expectation of government support lowers the cost of funds relative to what they would be otherwise.
To put it more simply, the TBTF funding argument is that Goldman, with implicit government support, pays less to issue bonds than Goldman without support would.
Reading the Goldman report, you might come away thinking that the principle difference between Goldman-or JPMorgan Chase, Bank of America, Citigroup, Wells Fargo and Morgan Stanley-on the one hand, and the smaller banks was simply size. But that's not true. The TBTF banks take on far more risk and far more debt than smaller banks.
Take UnionBanCal, the San Francisco subsidiary bank of the Mitsubishi UFJ Financial Group. It is a big bank with around $97 billion in assets. But Goldman, with $938 billion in total assets, is ten times the size. At the end of the last quarter, Union had a tangible common equity ratio of 10.5 percent; Goldman's was 6.95 percent. This means that where Goldman could be rendered insolvent by a 7 percent drop in the value of its assets, it would take a drop of greater than 10.5 percent for Union shareholders to be wiped out.
This example is a pretty good illustration of the difference between smaller banks and the TBTF variety. The average smaller bank has a tangible common equity ratio of between 9 percent and 10 percent. None of the six TBTFers has a tangible common equity ratio greater than 7 percent.
This should matter for bond investors. A 2009 McKinsey study found that one quarter of all banks with a tangible common equity ratios of less than 7.5 percent were distressed during the financial crisis, making up 83 percent of all distressed banks.
But, as the Goldman study shows, these risky, debt-laden banks pay only 10 basis point more on their debt post-crisis.
In other words, there is a TBTF subsidy. It's not as large as it once was, probably because the financial crisis made it clear that the largest financial institutions are far more fragile than almost anyone suspected prior to 2008. But it's there and plain enough to see.
It's a bit disturbing that Goldman doesn't seem to understand this. There misperception means that they are likely to misread or ignore market signals about the risks they take. Goldman-and the other TBTF banks-seem to still be blind to their own vulnerability-which is what got us in the financial crisis mess in the first place.
_By CNBC's John Carney. Follow me on Twitter @Carney