Risks to banks once cheap government-backed debt matures

NEW YORK Thu Jan 28, 2010 3:31pm EST

NEW YORK (Reuters) - Emergency funding the U.S. government provided during the credit crisis has left financial institutions with huge cut-price loans that could harm banks' profits and economic growth once borrowing costs rise.

Banks that borrowed cheaply in the corporate bond market with a government guarantee will see their borrowing costs rise sharply once the debt matures, analysts said. That may swell bank expenses and constrain their ability to lend.

By some time in 2012, about $309 billion of government-guaranteed debt outstanding under the Temporary Liquidity Guarantee Program (TLGP) will mature. Banks will have to refinance with their own stand-alone debt and will likely pay bondholders much higher yields.

"The rise in debt costs...will implicitly reduce banks' ability to lend," said Tim Backshall, chief strategist with Credit Derivatives Research, LLC.

The Program was one of many emergency measures the government brought in at the height of the financial crisis in late 2008 to stop lending markets from freezing up and prevent the financial system imploding.

Like other government stimulus programs, it has gone from reassuring financial markets to worrying them as investors await their eventual demise.

Back in 2008, investors were loath to buy any banks' stand-alone debt, plowing money instead into the securities issued under the TLGP program and driving their yields down. Bond yields and prices move inversely.

Backshall estimates the average yield of bonds issued under the TLGP program is about 0.7 percent.

But if banks issue new debt three years from now to replace the TLGP debt, the average yield could be as high as 4.7 percent for five-year maturities, Backshall said. That's based on forward markets that bet on future valuations.

The higher interest they will pay bondholders will push up interest expenses -- money paid out in interest on debt, Backshall warned.

"Banks' ability to lower interest expense over the past year due to the TLGP is tremendously misleading and we feel the TLGP represents a huge burden/drag on financial earnings in the coming years," Backshall wrote in a note last week.

If yields rise that much, Citigroup, Wells Fargo & Co, Bank of America and JPMorgan would all face a rise in annual interest expense of between 13 percent and 17 percent, Backshall estimates, which would be a major constraint on bank earnings. Contacted for this report, these banks either said they did not have forecasts or declined comment.

There are other options open to banks if refinancing at higher rates in intermediate and longer-term corporate bonds proves too expensive.

"They could perhaps borrow more overnight, go to the commercial paper market more aggressively, or shift to deposit-based funding," said Mark Freeman, portfolio manager with Westwood Holdings Group in Dallas, Texas.

Even so, the rise in borrowing costs via the corporate bond market will present a tough challenge. "They will have to be creative," Freeman said.

But for now, the TLGP subsidy for big institutions "has substantially lowered these banks' cost of capital and provided them with an amazing competitive advantage over the smaller and medium-sized banks across the country," said Haag Sherman, managing director of Salient Partners, a Houston based investment firm.

Bond investors are more confident in buying the debt of behemoth banks, which many believe are still implicitly backed by the government because it views these as too big to fail.

But investors are more wary of smaller regional banks, which are under growing pressure from a commercial real estate slide.

Differences between yields of the bonds issued by bigger and smaller banks show this divergence in their costs to borrow.

For instance, a five-year note issued by JPMorgan currently yields about 3.25 percent while a similar maturity note from mid-sized regional bank Zions Bancorp yields about 8.71 percent, according to MarketAxess.

(Reporting by John Parry; Editing by Andrew Hay)

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