Too big to fail worth $30 billion a year to big banks

By Rob Cox
March 29, 2010

No wonder banks like being too big to fail. The certainty of a bailout, should their bets go wrong, isn’t just reassuring to risk-taking employees. Customers also value infallibility. Measured by the interest rates banks of different sizes pay on deposits, America’s ten biggest banks benefit from this unfair subsidy to the tune of some $30 billion annually.

Legislators tussling over the details of bank reform might consider the math of deposit funding. Customer deposits are regarded as the cheapest and most stable source of funds for banks. That’s because all banks’ deposits are insured up to $250,000 per account by the Federal Deposit Insurance Corp.

The interest rates paid on those deposits vary widely. In the fourth quarter, institutions with more than $100 billion of assets paid an average of 0.77 percent annual interest on deposits, according to FDIC data. By comparison, institutions with less than $10 billion of assets paid an average 1.73 percent. That difference — nearly 1 percentage point — is one measure of the benefit that big banks enjoy from implicit government backing.

And it adds up to quite a bit. The ten largest banks hold about $3.2 trillion of America’s $7.7 billion of domestic deposits. Apply the differential in deposit interest rates, and the Big Ten appear be saving nearly $30 billion a year thanks to their size.

Big banks might argue that lower deposit funding costs reflect other advantages. For example, they offer more services and the convenience of more branches and ATMs than smaller banks. But that was the case before the government stepped in to save giant banks from the damage inflicted by subprime mortgages starting in 2007. FDIC data show that banks in all size categories paid between 3.60 percent 3.65 percent on deposits in the last quarter of 2006.

A return to that kind of level playing field could be one reasonable long-term goal for legislators and regulators. Meantime, President Barack Obama proposed big banks pay a “crisis responsibility fee” that would cost them $9 billion a year for ten years. He may have undershot the value of being too big to fail.

Private equity discount

Private equity-owned companies are suffering a credit — and possibly credibility — discount. Harrah’s Entertainment, the casino operator acquired three years ago for $27 billion by buyout firms TPG and Apollo, has outperformed publicly-listed rival MGM Mirage. But Harrah’s is still considered riskier. The persistent skepticism may reflect private equity’s track record of piling on debt and turning its back on troubled companies.

TPG and Apollo have kept Harrah’s in pretty good shape given the tough economy. Revenue fell 12 percent last year but aggressive cost cutting kept the operating profit margin flat. Earnings before interest, tax, depreciation and amortization fell in line with revenue — a rare feat in an industry with high fixed costs. Harrah’s also restructured its debt down to about 8.7 times operating cash flow from 10 at the end of 2008.

At MGM Mirage, revenue has fallen by about 13 percent after netting out the effect of selling assets. But its own earnings fell by a whopping 34 percent. As a result, debt that was once seven times EBITDA is now more than nine times.

Yet in the eyes of credit ratings agencies, Harrah’s is still considered riskier. Moody’s rates Harrah’s at Caa3 and MGM Mirage at Caa1, while Standard & Poor’s rates them the same. Investors also see Harrah’s as more likely to default. Its term loan was recently trading at 84 cents on the dollar, according to LSTA/LPC MTM Pricing. MGM’s senior debt was at 97.

This may be a case of private equity’s reputation catching up to it. Public companies tend to take a more balanced approach to raising money when they need it. Listed companies also have more ready access to raising cash. Buyout firms, of course, can inject more equity but also can — and often do — walk away more easily from troubled companies.

Harrah’s doesn’t seem like it will need new equity. It also isn’t in a position to lever up again. But the experience in Sin City may be exposing just how private equity is paying for past transgressions.

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