The Banking System: A Bad Moon Rising

I was never that big of a Credence Clearwater fan, but I couldn't help thinking of "Bad Moon Rising" when I saw this tidbit in an article on the banking crisis from the Washington Post (via MSN).

The health of many banks is getting worse, not better, as the downturn makes it difficult for all kinds of consumers and businesses to pay back money they borrowed from these financial firms. Conservative estimates put bank losses yet to be declared at $1 trillion.

I think it's fair to say that the American economy doesn't need another trillion dollars in bad news.

Actually, it gets worse.

Author David Cho goes on to look at the credit crunch and argues that the ability of banks to make loans depended on the mortgage based securities that are now on the wrong side of worthlessness.

Some help from the TARP bailout, government officials said, may go to jump-starting the credit markets that finance roughly half the debt owned by businesses and households. During the boom years earlier this decade, investors bought pools of mortgages and other kinds of loans packaged into securities, providing fresh funding for bank lending. But this activity ceased after traders lost confidence that the market was accurately pricing the value of these securities and assessing their risk.

If "normal bank lending" was indeed contingent on the highly speculative market in derivatives and credit default swaps (CDS) that relied on mortgage backed securities, the banking system as a whole was profoundly distorted and unsustainable for any kind of long term.

No doubt following up on his sources in the Obama administration, Cho suggests that the solution would be to put the derivative and CDS markets on a "more solid grounding."

The Federal Reserve is poised to launch an initiative in coming weeks to restart a segment of these markets by offering to buy highly rated commercial paper, backed by assets such as credit card debt, student loans and auto loans. Officials are considering expanding this initiative to help free up loans for municipalities, small businesses, commercial real estate and other consumer debt.

I'm not an economist but this just sounds disastrous. On the surface, it looks like the fed is looking to build an economic castle on a new pile of quicksand. How much more reliable can "credit card debt, student loans, and auto loans" be as a backing for securities than home mortgages? Not very!

There's another problem. If the derivative and CDS markets are tied to things like credit cards, student loans and auto loans, then there will be pressure to offer flimsy loans as a way to keep priming the financial markets. Eventually, the banking system would start falling apart again because of the inability of credit instruments to provide an adequate grounding for the financial markets.

What the Obama administration needs to do is to build (or rebuild) a credit system that does not depend on the derivative and CDS market for the credit needed to make necessary commercial and consumer loans.

If the administration can't accomplish that goal through reconstructed private lending agencies, then they're going to have to do it through some sort of government system.

Good luck with that!

Would Bank Nationalization Be So Bad?

One of the arguments against the nationalization of banks like Citigroup and Bank of America is that government officials can't manage banks:

So far the Obama administration has signaled that it is trying to avoid that day, and members of its economic team — among them Mr. Geithner and the president’s top economic adviser, Lawrence H. Summers — made the case during the Asian financial
crisis in the 1990s that governments make lousy bank managers.

But would "government bankers" really be worse than the current generation of major bank management which has lost hundreds of billions of dollars?

The answer to that is probably no.

Are Banks the No. 1 Threat to Capitalism? Fareed Zakaria has an article out for Newsweek entitled "Can Obama Save Capitalism." But I'm beginning to wonder if capitalism can be saved, or at least capitalism as we know it.

This is what got me wondering. Talking Points Memo features a post from someone in the real estate business who claims that banks are not using TARP money to lend for development projects. He quotes one banker as telling him that the banks have decided to use TARP money for buying other banks rather than new lending or renewing old loans.

As a commercial real estate attorney, I'm deeply involved with the current complete freeze-up of the commercial lending markets. I have many clients who have sound business practices in the development of commercial real estate.

Suddenly, and coinciding with the Lehman/Goldman fiasco, the commercial lending markets completely disappeared. Not just a slow down, but a complete and total shut down. Loans for which there were commitments were suddenly pulled. Term loans (most in the development world are for 1-2 years at a time) were suddenly not available for renewal putting borrowers in immediate default, or the lender required severe principal reductions in order to for the borrower to renew - severe to the point of not possible.

I'm not talking about over-speculative developers here asking for a bail-out. I'm talking about fiscally responsible developers, on-time payors with pared down staffs, who wrongly believed that the TARP funds going to the major banks would be put into circulation in the credit markets for new loans and renewals, which are the life-blood of the real estate industry. One bank had the temerity to tell me on a conference call that they were using the TARP funds for acquiring other banks,
not for new loans or renewals. And here lies the problem with the Paulson/Bernacke/ Frank plan...they once again trusted the banks "to do the right thing", (a la Greenspan), without requiring that the TARP funds go right back into the lending stream through the conduit of the banks. I'm not socialist, but I sure would agree for a Bank of US to come out of this mess. This is happening today, and the warnings are clear, and the results will be catastrophic.

If that claim is true, it's very interesting. Perhaps most importantly, it means that banks have decided that their "normal" business is mergers and acquisitions rather than lending.

But why is that the case?

I can't help but believe that bank executives believe that "buying other banks" is more profitable, better for the health of their companies, or more conducive for big bonuses and promotions than lending money to businesses.

Why that's the case is hard to tell. Perhaps the profits from lending are low because of low interest rates? One could argue that commercial ventures don't look very safe right now. But why would acquiring new banks look safer? It must might be that lending money looks boring, stodgy, or extremely limited in comparison to buying and selling other companies.

Whatever the reason, the reluctance to lend poses problems for American capitalism. First, the reluctance to lend undermines the rationale for using TARP funds for financial bailouts. If financial institutions just don't want to lend money to commercial enterprises, they won't use TARP money to restart lending. As a result, there is no reason to give bailout money to large-scale financial institutions. The money would be better devoted to creating an alternative for the commercial loans, consumer loans, and housing loans that business needs to get back on track.

In this context, the logic of the situation is that the government should be willing to take on a lending role for the next few years. Perhaps the TPM poster's "socialist" idea of a Bank of the US is the only way to generate the credit mechanisms needed to keep American business afloat.

The next question is whether private institutions are capable of providing the financial instruments needed for American business to function and grow. Right now, the jury is probably out on that, but it may be that the Obama administration needs to reimpose the Glass-Steagle Act that mandated the separation of commercial banks that primarily engaged in lending from brokerage houses that primarily engaged in investment.

To the extent that banks view themselves primarily as investment institutions, they may not be very useful for the American economy. The Obama administration should be gearing its policies toward re-making commercial banks as lending institutions. Otherwise, the government is going to have to become the primary lending institution in this country.