The Federal Reserve and other U.S. bank regulators have spent the past decade trying to shore up financial-industry rules to protect taxpayers from having to bail out big Wall Street firms.
Despite those efforts, a new study by researchers at the Fed's New York branch suggests that bondholders still don't believe the government would ever let the firms collapse. Those doubts are helping to prop up prices for the bonds of bank holding companies like Action Alerts Plus holding JPMorgan Chase & Co. , Bank of America Corp. Citigroup Inc. and Wells Fargo & Co.
But at least one analyst who tracks big Wall Street firms' bonds says there may be an even bigger problem: Investors simply don't care if the companies are too big to fail.
David Hendler, principal at the analysis firm Viola Research, says he speaks regularly with bond buyers for insurance companies and pension funds, and the topic rarely comes up. As he sees it, investors just need to buy bonds to fill up their portfolios, to keep income flowing in. And as long as banks appear healthy at the moment, the investors lap up bonds of big banks with little consideration of whether they might get their money back in the event of another financial crisis.
"Nobody cares," Hendler said in a phone interview. "Bond buyers are not interested in sacrificing yields because of theoreticals that they don't see."
Wall Street firms took such massive risks in the years leading up to the 2008 financial crisis that, when it hit, Congress had to allocate $700 billion of taxpayer money to keep the banking system from collapsing, even as the Federal Reserve lent the firms about $1.2 trillion through secretive emergency-lending programs.
Yet in 2006, as the crisis loomed, bank bonds showed few signs of distress; investors reveled in the profits the firms were booking from handling mortgages that would later sour as home prices fell. Investigators looking into the crisis afterward determined that many banks failed to evaluate borrowers' ability to repay their home loans.
And, in a way, that's what's happening now in the market for bank bonds; investors don't think too hard about whether they'll get paid back in the event of a market crash.
Since the 2008 crisis, regulators have forced banks to hold more capital - the cushion of extra assets that's supposed to protect depositors and bond investors from big losses, while also making bailouts less likely to be needed. Lawmakers also restricted banks from taking risky market bets with their own capital, through a provision known as the Volcker rule that banks are now lobbying to loosen.
The stiffer rules have made banks less likely to fail. Yet many critics of financial-industry deregulation say the government would still likely have to step in if a big bank - or several banks - ran into trouble when the next financial crisis hits.
The Dodd-Frank Act of 2010 revised the emergency authorities of the Fed and Federal Deposit Insurance Corp. so that bailouts can no longer target specific firms, while allowing broad-based rescue programs for the industry, if necessary.
Ratings agencies like Standard & Poor's and Moody's Investors Service responded to the new rules by incorporating them into bond-grading processes, accounting for the likelihood that big Wall Street banks' parent companies, in the event of big losses, might actually fail. The ratings firms, in other words, took lawmakers and regulators at their word.
But if investors don't also buy into the premise, there's a lack of "market discipline" - the concept that investor perceptions of increased risk theoretically should raise borrowing costs for big banks, in turn forcing the companies to scale back risky transactions made with borrowed money.
The U.S. Government Accountability Office noted the phenomenon in a 2014 report.
"If creditors and other counterparties do not fully charge a firm for the risks it is taking, that firm may have incentives to take on greater risks in the pursuit of higher returns," the report read. "Excessive risk-taking in response to such incentives can increase the likelihood that such a firm could become distressed and disrupt financial markets."
What's more, as investors load up on big-bank bonds, seeing no imminent risk of a crisis, the bonds become more broadly dispersed among insurance companies, pension funds and other investors that manage premiums and savings entrusted to them by policyholders, workers and retirees. That means the government might again be forced - via political pressure - to prevent deep losses.
And, given how rapidly financial losses cascaded across the financial system during the last crisis - because many banks were engaging in similarly risky activities - it's hard to believe the next crisis would be isolated to a single institution.
Such hypothetical scenario-plotting is beyond most investors, who just need to fill up their investment portfolios - today -- with whatever securities come to market, according to Hendler.
"It's not all pure risk-and-return analysis from a credit risk standpoint," he said. "It's also supply and demand of bonds."
A core regulatory process underlying the efforts to eliminate bailouts, if the worst-case scenario unfolds, is known as "resolution planning," as stipulated under the Dodd-Frank Act. Big Wall Street firms whose failure might spark a financial crisis - a la Lehman Brothers Holdings Inc. - are required to submit blueprints for how they could be closed without spreading catastrophic losses to creditors, trading partners and other banks.
In theory, Wall Street firms' operating bank subsidiaries, which are backed by the Federal Deposit Insurance Corp. and have access to the Fed's secretive emergency borrowing programs, are less risky than the parent companies, which lack the safety net.
Yet the New York Fed researchers found that bond yields for the Wall Street firms' parent companies trade aren't much higher than those on bonds issued by the banking subsidiaries - implying investors see little difference in their risk profiles.
"It's possible that investors are still skeptical about the new resolution tool since it has not yet been tested," the researchers wrote in a blog post. "It's also possible that bond markets' perceptions of risk differences between parent and subsidiary banks are concealed by the generally strong financial condition of the four institutions that we consider. Nonetheless, the absence of a market response is notable."
According to Hendler, the fundamental flaw of the research is the assumption that bondholders actually have an opinion on the matter.
"The market has business needs that don't synchronize with risk concerns," Hendler said. "There's no self-discipline. It's all, I need to perform now."
The New York Fed researchers -- Gara Alfonso, Michael Blank and Joao Santos -- declined to respond to Hendler's criticisms on the record.
In the meantime, bankers and government officials have proudly declared that the quandary of "too big to fail" has been solved.
JPMorgan CEO Jamie Dimon wrote in an annual letter to shareholders last year that regulators now have the ability to unwind not just failing banks but also investment banks - an authority that didn't exist prior to the 2008 crisis. They also can convert some bondholders' money into equity at the time of failure, immediately recapitalizing the failed bank, Dimon noted.
"These changes, taken together, not only largely eliminate the chance of a major bank failing today but also prevent such failure from having a threatening domino effect on other banks and the economy as a whole," Dimon wrote. "Essentially, too big to fail has been solved. Taxpayers will not pay if a bank fails."
JPMorgan press officials didn't respond to a request for comment for this article.
The GAO, in its 2014 report, found that "clear funding-cost advantages" for the largest bank holding companies, evident during the financial crisis, had declined or reversed by 2013.
"We believe these results reflect increased market recognition of what should now be evident: Dodd-Frank ended `too big to fail,'" Mary Miller, an undersecretary of the Treasury at the time, wrote in a letter attached to the GAO report.
Even so, when the GAO interviewed 16 mutual funds, hedge funds, corporations and other institutions that buy bank bonds, they responded that although there had been "significant progress in reducing expectations of government support," the investors still believed that "the government might not allow the largest bank holding companies to fail."
To Viola's Hendler, the whole debate is beside the point. Little is changed, in his mind - because the broader financial system is still dependent on big banks, and investors blithely buy their bonds whether they're too big to fail, or not.
"The analyst isn't willing to be bold and go to their trading desk and say, `You know, you really shouldn't buy the bank holding-company bond.' The traders and portfolio managers are just going to say, `Oh, c'mon, there's no risk. Maybe five years from now, but right now I need the extra yield, and if we get that we'll have more money coming in here and I'll be able to beat the index.'"
And maybe get a bigger bonus - enough to really care about.