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Don’t be fooled, too big to fail is alive and well

September 22, 2011, 7:24 PM UTC

Still too big to fail

Is “too big to fail” just a distant memory? That’s what Moody’s seems to be telegraphing to the market after it slashed the credit ratings of Citigroup, Wells Fargo (WFC) and Bank of America on Wednesday. But while the government says it is no longer in the bailout business, it is hard to believe that moral hazard is dead. After all, the banks are bigger and more interconnected than ever before, making a potential failure far more devastating than when the government allowed Lehman Brothers to collapse in the fall of 2008.

In downgrading the big U.S. banks yesterday, Moody’s was cautious to note that the intrinsic credit worthiness of the banks in question had not changed. What had changed in Moody’s eye was the idea that the government would automatically step in and bail them out if they ever found themselves in hot water. While Moody’s noted that the government was likely to continue to provide some level of support, it said that the government was also “more likely now than during the financial crisis to allow a large bank to fail should it become financially troubled.”

The impetus for this change in thinking was rooted in the passage of the Dodd-Frank Wall Street reform bill, which was put into law with great fanfare in the summer of 2010. One of the major tenets of the nearly 2,000-page law was that the big banks would never be coddled again if they were facing imminent collapse. A structure would be put in place to allow for the banks to fail in an orderly fashion. In addition, the large systemically important banks would be required to write “living wills” to help the government navigate their collapse if it indeed occurred at some point in the future.

But while the idea of an organized implosion sounds great, it is hard to believe that the government would ever let it happen, especially given today’s weak economy. After all, a controlled implosion of a systemically important banking institution seems to be an oxymoron given the deep interconnectedness of the banking system. A full year has passed since Dodd-Frank went into force and it is still unclear how the government would allow for a big bank to simply fail. Additional regulations to be imposed on the big banks have yet to be written, like rules that dictate minimum capital requirements. And those “living wills?” The banks haven’t written them yet.

So it’s hard to say how the government can better prevent a bank from failing or how they would be able to control the fallout from such a failure. All they say is that it is “illegal” to bail them out. That may be true, but in times of crisis, rules tend to be broken.

Insider buying in financials soared in August

What is clear is that the banks today are far bigger and more interconnected than they were back in 2008 — and they are still engaging in what some might consider to be risky behavior. Take credit default swaps. AIG (AIG) required a nearly $80 billion bailout from the government in the fall of 2008 because it had failed to put enough capital aside to cover the billions of dollars worth of credit default swaps it had sold to various banks and financial institutions.

Fast forward to 2011, and there are still no real concrete standards when it comes to this $30 trillion market. The big banks continue to write billions of dollars worth of bespoke CDS contracts on almost any security you can imagine, most without setting aside enough capital to cover a potential claim, traders tell Fortune. This is troubling, since investors are increasingly turning to the CDS market to figure out the credit worthiness of a company or country, driving up demand.

A failure of a major financial institution with billions of dollars of outstanding CDS contracts is a scenario that is all too plausible. Since these banks all trade with one another, the failure of one will cause ripple effects throughout the financial system. After all, the government didn’t just bail out AIG to save it from going under, it did it to help out many of the world’s largest banks, including Goldman Sachs (GS), which had entered into billions of dollars worth of CDS contracts with AIG.

Bank of America: Big bank, bigger worry

CDS contracts are just one of the myriad of ways banks are connected in the shadows, out of sight of both the government and most investors. This lack of transparency into the banking sector could sow the seeds of another crisis. If a major bank fails today, the markets would most likely freeze up like it did after Lehman Brothers failed in 2008. Banks would refuse to lend to each other and hoard capital, translating to a devastating credit crunch.

But even if all the interconnectivity and transparency problems were solved, the failure of a megabank would still be devastating to the economy due solely to its sheer size. Bank of America alone has over $2.5 trillion in assets, which is equivalent to around 18% of US GDP. The bank has exposure to nearly every financial vertical on Wall Street, from investment banking to CDS underwriting. And unlike at they did at Lehman, ordinary Americans have an intimate relationship with Bank of America through their home loans, basic checking accounts and credit cards. A failure would set off a public panic that would probably make the Lehman failure look like a walk in the park.

Bank of America (BAC) is also heavily exposed to the U.S. mortgage market, which has caused it a ton of grief in recent weeks. The bank’s share price has fallen over 40% in the past three months as a result of its mortgage woes. In response, the bank is firing thousands of employees and raising billions of dollars in capital to placate the market. But that might not be enough. The two-notch downgrade by Moody’s, which analysts said was already priced into the stock, sent investors stampeding for the exits, sending the bank’s shares down 7.5% Wednesday and another 4% by mid-day on Thursday to levels not seen since the financial crisis.

Bank of America’s fate remains at the mercy of the market. The thought that the bank doesn’t have an implicit government guarantee has made it less desirable to own, threatening its survival. But it is hard to believe that the government is unaware what a Bank of America failure would mean to the banking system and the economy. Such a failure – orderly or not – will probably not be allowed to happen.

The only real way to ensure a bank is not too big to fail would be to cap the amount of assets that a bank could hold. Twenty years ago, Citigroup (C), the largest bank at the time, held around a tenth of the assets held by Bank of America today. Efforts to break up the banks have fallen on deaf ears on both sides of the aisle in Washington. Until the banks shrink to a manageable size, it seems like the implicit government guarantee will still be there – legal or not.