(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.
Failed Model
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.
'Distorted Incentives'
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.
Risk Tolerance
"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.
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