Bond bets show government favors banks over autos

NEW YORK (Reuters) - Although the near term outlook for U.S. banks remains dismal, bond investors are betting the government will bail out behemoth financial institutions even as it lets some automakers fail.

As flagship automakers struggle to avert bankruptcy and with fears growing that government funding for them will soon dry up, investors in the companies have watched the bonds' prices drop to pennies on the dollar.

By contrast, bonds of major financial institutions the U.S. government is expected to save have clambered back from record price lows in March.

"If you look at the difference between banks bonds' and automakers it is really in the way the government has treated them," said Haag Sherman, co-founder and managing director of Salient Partners, a Houston based investment firm.

In the near term, investors are anxious about the results of stress tests that regulators are conducting on banks to gauge how much more capital they may need, which is weighing on bond prices. There is also worry about how much more banks will lose from sliding commercial real estate and opaque bets in the huge derivatives markets.

Yet longer term, the bonds of banks that have government support may emerge stronger as the industry consolidates in the aftermath of the biggest financial shock since the Great Depression, some expect.

While the government may ultimately let car makers go to the wall, "the market is saying effectively the government will not punish the banks' bondholders at all," Sherman said.

That applies only to those banks that the government is committed to support.

Because the global financial system came close to collapse after Lehman Brothers cratered in September, bond investors reckon the U.S. government is determined to save all systemically important financial institutions. That belief will underpin these banks' bonds so long as the government can sell enough debt to pay for bailouts, analysts said.

"These banks when they come out the other side (of the global credit crisis) will have tremendous earnings power. You are consolidating institutions and eliminating a lot of competition," Sherman said.

The outlook for automakers, by contrast, is bleak.

"The key difference is that banks are involved in every facet of our economy because they lend, whereas Detroit's impact is somewhat limited because it is one sector of the economy," said Sung Won Sohn, professor of economics at California State University in Camarillo.

"That's the reason why the government has been more involved in banks than it has in manufacturers," he added.

The government created a $700 billion bailout fund to support financial institutions weakened by the credit crisis, and injected funds in more than 500 banks, typically receiving preferred shares in return. By some analyst estimates, several major banks could need more capital to stay afloat.

U.S.-based automakers and suppliers are seeking more than $100 billion of total government aid. But analysts say the political will to subsidize this sector more is fading.

Banks "are considered to be too big to fail, whereas GM is not," said Sohn. "The bond market does reflect this," said Sohn. "Some of the auto bonds are essentially worthless, whereas bank bonds are holding some value," he said.

General Motors' benchmark bonds maturing in 2033 traded at about 9 cents on the dollar on Wednesday. By contrast a Citigroup bond maturing in 2036, which is among the most actively traded, traded at 58.5 cents on Wednesday. Many analysts consider Citigroup (C.N), especially hard hit by credit losses, as quasi-nationalized already.

As regulators' exam results for banks come out, the bonds of banks perceived to be the weakest are being hurt by concerns some big banks may need extra government capital if the economy worsens and housing-related assets fall, analysts said.

On such fears, U.S. financial institutions' bond yield spreads hit record wides in early March of about 880 basis points over Treasuries, narrowing to 734 basis points on Tuesday, according to Merrill Lynch data.

Yet the most bearish analysts forecast the financial system will suffer much more, ultimately battering banks' bonds as much as those of automakers.

"The endgame is going to naturally wind up on a similar path," said Martin Weiss, president of Weiss Research Inc. in Jupiter, Florida and author of a book published this month; "The Ultimate Depression Survival Guide."

"What will push us toward that similar path is a very simple fact. Money is going to run out," Weiss said.

(Reporting by John Parry; Editing by Chizu Nomiyama)