Bond spreads create new bank crisis barometer

NEW YORK Wed Mar 25, 2009 6:04pm EDT

A businessman uses his mobile phone from across the former Lehman Brothers, now Barclays Capital building in Times Square in New York September 23, 2008. REUTERS/Erin Siegal

A businessman uses his mobile phone from across the former Lehman Brothers, now Barclays Capital building in Times Square in New York September 23, 2008.

Credit: Reuters/Erin Siegal

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NEW YORK (Reuters) - Investors seeking clues to whether U.S. banks are recovering from their malaise are weighing a new bond yield spread as a barometer.

The difference in yield between bank debt issued under a program offering a government guarantee and traditional debt that carries no such backing is being watched as a measure of confidence in the system.

The failure of Lehman Brothers and last-ditch government rescues of several major financial institutions late last year prompted investors to dump bank debt in favor of the perceived safe haven of Treasury debt.

But since November -- under one of many government programs aimed at breathing life into ailing debt markets -- $312 billion of bank debt has been issued under government guarantee by the Federal Deposit Insurance Corp (FDIC). The government backing has given investors the confidence to venture into the new bonds.

Only a brave few are actively seeking other types of bank debt, in a bet that the credit crisis will eventually ease and banks will make profits.

"Some market participants are buying debt beyond the guarantee window with the thought the banks will return to a solid footing," said Jim Platz, senior portfolio manager in Mountain View, California with fund manager American Century Investments.

A narrowing of the yield spreads of non-guaranteed bank debt over government-supported debt in the next three years, when the new debt will mature, would indicate that investors are regaining confidence in the banking system, analysts say.

ROCKY ROAD BACK

But investors' faith in financial institutions has been sorely tested, and the road back will likely be rocky, analysts said.

New issuance of traditional corporate debt from U.S. financial institutions -- a mainstay of the corporate bond market before the global financial crisis erupted -- has virtually dried up since late last year.

For now, the yield gap of about 4 percentage points between the government-guaranteed bonds and other bank bonds is, in effect, a vote of no-confidence by investors that the gutted banking sector can operate without huge government support.

It's also one of many new trading possibilities for fund managers seeking to exploit wide valuation gaps between different types of bonds after the huge dislocations caused by investors' stampede out of riskier assets during the panic of 2008.

"The government has perhaps inadvertently created many arbitrage opportunities for traders in their efforts to backstop banks' debt," said Jes Black an analyst and fund manager with NetBlack Capital, a New York-based currency fund.

Over the short term, if the government's latest rescue plan to relieve banks of up to $1 trillion in mortgage securities and other toxic assets helps steady loss-burdened banks, then bond traders may buy some unprotected bank debt in a bet that the financial system is on the road to recovery.

If enough investors are willing to take on the risk of holding traditional bank bonds again, the high yields they now demand for the extra risk will fall, pushing those bonds' prices up.

Such buying would narrow the spread of this traditional bank debt, yielding about 6 percent, over FDIC-backed issuance of comparable maturities, which yields close to 2 percent.

"In the short term, you will see a gradual spread compression as these (government) plans get going that will help pull some of the toxic stuff out of the banking system," said Scott MacDonald, head of research at Aladdin Capital in Stamford, Connecticut.

Others still rely on conventional bank debt's spread over safer government Treasuries as a trusted indicator of financial system risk, with a history that long predates the start of the credit crisis in mid-2007.

"What you would want to look at is the historical relationship between the financial sector and the Treasury market before all this began to explode," said Cam Albright, managing director of fixed income for fund manager Wilmington Trust's investment management unit in Wilmington, Delaware.

Before then, yield spreads of U.S. bank debt over Treasuries were in the range of 1 to 1.5 percentage points, he said. Now, some of these yields are trading about 5 percentage points over government securities.

(Reporting by John Parry; editing by Jonathan Oatis)

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