RISKS OF DANCING ON THE DEBT CEILING / THE WALL STREET JOURNAL ( A MUST READ )

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JULY 22, 2011, 4:53 P.M. ET.

Risks of Dancing on the Debt Ceiling


By DAVID REILLY

There will be blood. The trouble for investors is that it isn't clear how much banks will shed if the U.S. government can't resolve the debt crisis.


Part of that depends on whether the result of political failure is a downgrade of U.S. debt, or if the government defaults. The latter could wallop banks, especially if it caused a calamity akin to the run on money-market funds following Lehman Brothers' collapse.


A ratings downgrade should have more limited impact. But investors will still focus on the too-big-to-fail banks: Bank of America, Citigroup, J.P. Morgan Chase, Wells Fargo, Goldman Sachs and Morgan Stanley. This is because, together, these six institutions at the end of the first quarter held $1 trillion in U.S. debt, agency securities and government-backed mortgage bonds.

That is equal to about 60% of the $1.6 trillion held by all U.S. commercial banks, according to Federal Reserve data. These firms also held nearly $80 billion in debt issued by states and local governments.


Among the banks, Citigroup was the biggest holder of U.S. Treasurys and agency securities, with about $130 billion. Bank of America had the largest amount of government-backed mortgage securities, at $227 billion. Government obligations at Goldman Sachs were equal to 12% of its total assets.


The huge sums underscore the continued concentration of risk within the U.S. financial system. The big danger of a downgrade is forced-selling by those who need to hold triple-A paper. Such an impact is hard to quantify. But if there is no big lurch down in the value of Treasurys and other government-backed debt, the threat shouldn't be too great.


Banks are likely to be all right in terms of capital. This is because measures of it are based on assets weighted for the risk they pose. As Barclays Capital bank credit analyst Jonathan Glionna pointed out in a recent note, U.S. Treasury obligations generally receive a 0% risk weighting, while debt associated with agencies such as Fannie Mae and Freddie Mac are typically at 20%. This likely wouldn't change due to a government downgrade. So banks shouldn't generally be required by regulators to hold more capital.


Banks could face hits to equity. But elsewhere in their books, the impact isn't clear cut and depends on how each bank designates assets. For example, losses on U.S. government bonds in a bank's trading book would immediately hit earnings. But banks often classify holdings as "available for sale;" 86% of Citi's Treasury and agency holdings are designated this way. In this case, losses are quarantined in shareholders equity and don't immediately hit profit.


Banks also use U.S. government debt as collateral for short-term borrowing. A downgrade could force them to put up larger amounts of collateral, raising their cost of borrowing.


Still, the direct hit to the banks shouldn't be catastrophic—so long as the government sidesteps an actual default, and the chance of another Lehman moment.
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