Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Is BofA Befuddled by Mixed Market Messages?

Bank of America flag
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One of the reason Bank of America may not be able to come to grips with its capital situation is that it is getting mixed signals from the market.

The part of the market that is usually the clearest indicator of risk perception is the bond market. You know, those famous bond vigilantes who are always hunting down the too risky or over-leveraged.

But the bond market isn’t punishing Bank of America . The interest rates Bank of America is required to pay aren’t shooting through the roof. The cost of insuring Bank of America’s debt is high—but not at a point where alarm bells are ringing.

Looked at through the lens of the bond market, the idea that Bank of America might be at heightened risk for financial distress or insolvency is ludicrous.

Meanwhile, equity investors have imposed a severe discount to Bank of America’s shares. As I argued earlier, I believe the source of this discount is perceived risk. But equity markets are far harder to read, especially when it comes to risk perception, than bond markets.

So why are equity markets behaving in more risk adverse way than bond markets when it comes to Bank of America? My suggestion is that the expectation that Bank of America is "too big to fail" bolsters the confidence of creditors more than it does shareholders. Shareholders worry that they will suffer if the bank becomes distressed, while bondholders have a great deal of confidence that they will bailed out.

I know that Dodd-Frank is supposed to prevent this. But I don’t think that markets believe that Dodd-Frank’s anti-bailout provisions will stick when push comes to shove.


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