(Bloomberg) -- Shareholders of Wall Street banks who agree with former Citigroup Inc. Chief Executive Officer Sanford "Sandy" Weill that the companies should be broken up face an obstacle: bondholders.
That's because trading on Wall Street relies on borrowed money, or leverage, that can be obtained cheaply as long as the traders belong to a conglomerate such as Bank of America Corp., JPMorgan Chase & Co. or Citigroup that gets federally insured deposits. Jefferies Group Inc., a securities firm that isn't part of a bank and can't turn to the Federal Reserve for help, currently is charged more to borrow in the credit markets.
"If you divorce them from the mother ship, you'd also be divorcing them from the government at the same time, and that's where the subsidy is," Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University, said in a telephone interview. "The funding advantage is the key."
With stock prices at or below liquidation value, Wall Street's biggest banks are fending off calls to break up from stockholders, analysts and industry veterans including Weill. The firms are too complex to manage, over-burdened by regulation, and a risk to taxpayers, their critics say.
Financial companies have sold or spun off units to improve shareholder returns. Under Weill's leadership, Citigroup sold shares of Travelers Property Casualty Corp. to the public in 2002. American Express Co. divested most of Shearson in 1993 and spun off Lehman Brothers a year later. What's different today is that securities firms, such as Bank of America's Merrill Lynch, are benefiting from a funding discount.
The 2008 collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc., as well as last year's bankruptcy of MF Global Holdings Ltd., taught investors that securities firms not attached to banks are riskier than they once acknowledged. Merrill Lynch & Co. agreed to sell itself to Bank of America the same day Lehman declared bankruptcy. A week later Goldman Sachs Group Inc. and Morgan Stanley converted to bank holding companies that are regulated by the Fed.
Breaking up today's banking conglomerates would mean restoring the old model of financing securities firms in the bond markets, which failed in 2008. Without Bank of America's $1.04 trillion of deposits -- about 80 percent of them federally insured, according to Jerry Dubrowski, a company spokesman -- Merrill Lynch would have to depend again on capital markets to fund trading and back up derivatives contracts.
The big Wall Street banks are today what government- sponsored enterprises such as Fannie Mae and Freddie Mac used to be, producing profits for employees and shareholders even as taxpayers bear the ultimate risk, according to Simon Johnson, a former chief economist for the International Monetary Fund who's now a professor at the Massachusetts Institute of Technology's Sloan School of Management and a contributor to Bloomberg View.
"They are the GSEs of today with big downside guarantees and distorted incentives," Johnson said. "We should restore the free market and cut off the subsidies."
Jefferies, the biggest U.S. securities firm that isn't attached to a depository institution, cut European debt holdings last year by almost 75 percent to calm investors in the wake of MF Global's collapse. Jefferies had $9.81 of assets for every dollar of equity as of May 31, down from $12.92 at the end of August 2011, according to company reports.
"I don't think there's a lot of tolerance for risk like there was before," Scott MacDonald, head of research at fixed- income investment firm MC Asset Management Holdings LLC in Stamford, Connecticut, said in a telephone interview. "Investor sentiment has changed. For many investors, leverage remains a four-letter word and probably will be going forward."
Jefferies's bond yields show that it costs the firm about 5.81 percent to borrow until 2021. That's more than the 4.38 percent yield on 2022 debt issued by Goldman Sachs. While Bank of America has the same Baa2 credit rating from Moody's Investors Service as Jefferies -- two levels below Goldman Sachs's A3 rating -- its 2022 bonds yield 3.99 percent.
As record-low interest rates limit returns on assets, banks have become more focused than ever on funding costs. That's led them to lean more on the cheapest form of borrowing available: federally insured deposits.
Bank of America pays about $500 million a quarter in interest for its $1 trillion of deposits compared with about $2.5 billion for $300 billion of long-term debt, CEO Brian T. Moynihan, 52, said on a July 18 investor call. Those figures don't include fees that the Charlotte, North Carolina-based lender pays to the Federal Deposit Insurance Corp.
The bank reduced its long-term debt by $53 billion in the second quarter. It didn't issue any long-term debt in the period and doesn't expect to this year, Chief Financial Officer Bruce Thompson said.
Eric W. Aboaf, treasurer of New York-based Citigroup, told a similar story to investors on a July 20 conference call.
"We have been focused on reducing our borrowing costs by substituting maturing long-term debt in the bank, which is a more expensive source of funding, with deposits, our lowest cost of funds," said Aboaf, 48.
JPMorgan, led by Weill's former deputy Jamie Dimon, 56, makes more money from debt trading than any other lender. Still, the New York-based firm finances its own operations with $1.12 trillion of deposits and $982.7 billion of market borrowing.
"Our deposit growth has been more than twice the growth of our competitors, and the best part of that story is that we're doing it with a lot of pricing discipline," Todd Maclin, co-CEO of consumer and community banking, said during a May 8 investor presentation. "Many of our competitors are using pricing to attract deposits, and we're fortunate in not having to meet them on those same terms."
Goldman Sachs has more than doubled its deposit base to $57 billion since 2008 and wants to raise more because the cost of three-year deposits is about 200 basis points, or 2 percentage points, fewer than issuing three-year debt in the bond market, Treasurer Elizabeth Beshel Robinson said July 24.
"The market is a little bit more challenging today than it's been in the past," Robinson, 43, said on a conference call with fixed-income investors, the first the company has convened. Solutions include using the New York-based firm's excess cash, "using some of the deposit growth to fund some assets, or perhaps even reducing some funding-intensive assets," she said.
Weill, 79, who arranged the 1998 merger of Travelers Group Inc. and Citicorp that ushered in the era of so-called universal banks in the U.S., said in a July 25 interview on CNBC that investment banks and commercial banks should be separated.
"Have banks do something that's not going to risk taxpayer dollars, that's not going to be too big to fail," Weill said.
While some regulators, economists and other banking- industry veterans have made similar statements, the view was a surprise coming from Weill. His deal creating Citigroup required repeal of the Depression-era Glass-Steagall Act, which forced deposit-taking companies backed by government insurance to be separate from investment banks. A decade later, Citigroup needed a $45 billion taxpayer bailout to avoid collapse.
Advocates of the universal-bank model say the 1999 Gramm- Leach-Bliley Act, which overturned Glass-Steagall, didn't make the federally insured units any riskier because regulations bar capital transfers between entities within the holding companies.
Federal law limits regulated bank subsidiaries of holding companies from making loans to their affiliates that exceed 20 percent of the bank's capital stock and surplus. That limitation was suspended by the Fed on Sept. 14, 2008, and wasn't reinstated until Oct. 30, 2009.
About 99 percent of JPMorgan's $79 trillion derivatives book is in its deposit-taking subsidiary, according to data as of June 30 compiled by the Office of the Comptroller of the Currency. The figure for Bank of America is 71 percent.
When Merrill Lynch's credit rating was lowered by Moody's last September, the company responded by seeking permission to move some of its derivatives contracts to the higher-rated and federally backed Bank of America NA subsidiary. The Fed signaled that it favored granting the request, while the FDIC, which would have to pay depositors if the bank subsidiary failed, objected, people with knowledge of the matter said at the time.
"For a lot of the activities that these companies engage in, the confidence of their counterparties is really confidence not in them, but confidence in the government bailing out their affiliated bank," Boston University's Hurley said.
Bank of America, JPMorgan and Goldman Sachs are safer to own than a "high-risk security" such as Jefferies, said William Larkin, a fixed-income money manager who helps oversee $500 million, including bonds of the three banks, at Cabot Money Management Inc. in Salem, Massachusetts. He said he doesn't believe statements by government officials and regulators that no bank is too big to fail.
"When I look at companies, I think, 'What can kill the company?' And right off the bat I say the exact opposite of what the government says. I say, 'That's a company that's too big to fail,'" he said of Bank of America. "So that protects me."
It also protects Merrill Lynch. A year ago, as the European sovereign-debt crisis roiled markets, traders charged 78 basis points more for credit-default swaps on debt issued by Merrill Lynch than on debt of its parent, Bank of America, as Merrill Lynch was perceived as riskier. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, minus the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Now, the gap is just 7.6 basis points, and was as little as 2.5 basis points last month, the narrowest in more than a year, according to data provider CMA, indicating traders' perceptions of the two entities' creditworthiness is converging.
"If the investment banks are spun out from the universal banks, the resulting entity would likely need more capital than it does as part of the universal firm," Michael Mayo, an analyst at CLSA Ltd. and "Exile on Wall Street" author, said in an Aug. 21 note to investors in which he argued that Citigroup is worth more broken up than left whole. "You're going to need more capital to reassure the creditors."
Betsy Graseck, a Morgan Stanley analyst, offered a similar assessment in an Aug. 1 Bloomberg Television interview.
"When you do a basic sum of the parts of these companies, you can come up with a higher price than where they're trading today," Graseck said. "But the challenge is, do each of these companies have enough capital and liquidity to support breaking them up into four, five, six sub-components?"
The attitude of bond investors such as Larkin, who said he feels safe lending to the biggest banks because he expects them to be bailed out by the government in the event of a crisis, is one reason regulators are eager to require the largest firms to hold the highest percentage of capital, a so-called surcharge, Fed Chairman Ben S. Bernanke said at a Jan. 25 press conference.
"A bank which is thought to be too big to fail gets an artificial subsidy in the interest rate that it can borrow at," Bernanke said. "And by having additional capital requirements, that tends to equalize the cost of funding to different banks, and reduces the incentives of banks to get large just to create the impression of being too big to fail."
William B. Harrison Jr., the former JPMorgan CEO who arranged its 2004 purchase of Bank One Corp., wrote in an opinion piece in the New York Times last month that the biggest banks don't have an implicit advantage. A bank rated AA deemed too big to fail can't borrow any more cheaply than a similarly rated industrial company, Harrison wrote.
None of the six biggest U.S. bank holding companies, including JPMorgan, has a credit rating as high as AA from Moody's or Standard & Poor's. What does are the bonds of JPMorgan's federally insured subsidiaries, which have Aa3 ratings from Moody's, according to the bank's website.
In comparing lenders to industrial companies, Harrison didn't mention the advantage deposits provide to financial firms. About 22 percent of the $1.68 trillion of liabilities at one of JPMorgan's subsidiaries were non-interest-bearing deposits, according to a second-quarter report filed with federal regulators. International Business Machines Corp., with the same Moody's rating, doesn't borrow any money interest-free.
JPMorgan's deposits aren't entirely without cost. The bank has to pay fees to the FDIC based on the company's average assets minus tangible equity. Its rate, which is pegged to the riskiness of assets and liabilities, is 10 basis points, or 0.10 percentage point, Dimon said on an Oct. 13 conference call.
Wall Street today is "deposit-funded, and the deposits themselves are guaranteed by the government," said Boston University's Hurley. "It's a huge part of the franchise of Dimon and Moynihan, and yet they're going to be the last people on the planet to admit it."
Stock investors such as Michael F. Price, president of MFP Investors LLC in New York, and analysts including JMP Securities LLC's David Trone have said stock prices show that the biggest banks will struggle to make money because of new capital requirements, regulation and complex business models.
"They worked well together in the old world," Price, a money manager who in 1995 helped spur the merger of Chase Manhattan Corp. and Chemical Banking Corp., said in June. "That was the analog world. This is the digital world."
The biggest securities firms, if they tried to untether themselves from regulated banks, might not escape the capital requirements and Dodd-Frank regulations that apply to systemically important firms. Jefferies, with $35.7 billion of assets at the end of May, probably isn't too big to fail. Merrill Lynch, with about $600 billion in assets at the end of June, might be.
Bond markets, and some stock investors, may be unwilling to support a large, multinational securities firm that doesn't have diversified funding, including federally insured deposits and so-called wholesale funding from bond investors.
"The financial crisis has shown us that the independent investment-banking model doesn't really work that well," Kush Goel, a senior vice president and research analyst in the financial-services group at Neuberger Berman Group LLC, said in a telephone interview. Goel joined Neuberger in 2006, when it was still part of Lehman Brothers.
"Some people might say, 'I don't want to buy that, I don't care what returns they promise, I don't care what it is, I won't touch something which is entirely wholesale funded,'" he said.