U.S. Forcing Banks to Resume Lending at Bazooka Point

By: Mike_Shedlock

For now, you can force banks to take money, but you can't force them to lend it. Let's explore this theory starting with a look at the Drama Behind a $250 Billion Banking Deal .

The chief executives of the nine largest banks in the United States trooped into a gilded conference room at the Treasury Department at 3 p.m. Monday. To their astonishment, they were each handed a one-page document that said they agreed to sell shares to the government, then Treasury Secretary Henry M. Paulson Jr. said they must sign it before they left.

The chairman of JPMorgan Chase, Jamie Dimon, was receptive, saying he thought the deal looked pretty good once he ran the numbers through his head. The chairman of Wells Fargo, Richard M. Kovacevich, protested strongly that, unlike his New York rivals, his bank was not in trouble because of investments in exotic mortgages, and did not need a bailout, according to people briefed on the meeting.

But by 6:30, all nine chief executives had signed — setting in motion the largest government intervention in the American banking system since the Depression and retreating from the rescue plan Mr. Paulson had fought so hard to get through Congress only two weeks earlier.

What happened during those three and a half hours is a story of high drama and brief conflict, followed by acquiescence by the bankers, who felt they had little choice but to go along with the Treasury plan to inject $250 billion of capital into thousands of banks — starting with theirs.

In addition to the capital infusions, which will be made this week, the government said it would temporarily guarantee $1.5 trillion in new senior debt issued by banks, as well as insure $500 billion in deposits in noninterest-bearing accounts, mainly used by businesses.

All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks. The latest show of government firepower is an abrupt about-face for Mr. Paulson, who just days earlier was discouraging the idea of capital injections for banks.

The Treasury will receive preferred shares that pay a 5 percent dividend, rising to 9 percent after five years. It will get warrants to purchase common shares, equivalent to 15 percent of its initial investment. But the Treasury said it would not exercise its right to vote those common shares.

“It was a take it or take it offer,” said one person who was briefed on the meeting, speaking on condition of anonymity because the discussions were private. “Everyone knew there was only one answer.”

Compelling Banks to Put New Cash to Work

Bloomberg is reporting Paulson Lacks Leverage to Compel Banks to Put New Cash to Work .

Treasury Secretary Henry Paulson persuaded nine major U.S. banks to accept $125 billion in government investment. Getting them to lend it out may prove a tougher sell. [Mish note: The other $125 billion goes to hundreds or thousands of smaller banks]

"The truth of the matter is, they can't put a gun to their head and say you have to lend this money," said Charles Horn, a former official at the Office of the Comptroller of the Currency, part of the Treasury Department, and now a partner at the Mayer Brown law firm in Washington.

Treasury officials acknowledge they can't force banks to get the taxpayer money into the hands of their customers. Instead, officials are betting that the government's investment will create conditions where banks have a greater incentive to earn profits from lending than to hoard money to shore up their balance sheets.

"It's in their economic interest," said David Nason, the Treasury's assistant secretary for financial institutions, in an interview with Bloomberg Television.

Bazooka Theory

There seems to be a fine line between ...
1) Illegally forcing supposedly well capitalized banks at bazooka point to take money on questionable terms
2) And illegally forcing those same banks at bazooka point to lend it

Self Preservation

I hope that fine dividing line holds and I also hope banks do the responsible thing (nothing) because Paulson is acting like a complete fool. It is in no one's best interest to lend that much money. We are in this mess because banks lent money to anyone and everyone including those with no possible means of paying the money back.

The US is in a recession, consumers are cutting back discretionary spending, there is rampant overcapacity in every sector but energy, and there is no reason to go on a lending spree. Furthermore, there is no reason for any qualified buyer to want to borrow. Why would any responsible party want to expand in this environment? The only people who want to borrow significant sums of money now are the very people banks should not want to lend to.

Thus the best thing banks can do with that money is sit on it. Yet the penalty for sitting on it is the difference between what the Fed will pay on bank reserves and the 5% interest banks have to pay at bazooka point for borrowing money they did not want in the first place. If banks do start lending like Paulson wants, defaults are guaranteed to increase dramatically.

Pretend Lending And LIBOR

LIBOR is based on rates for bank to bank lending. That lending is simply not happening as noted in LIBOR and the TED Spread Still Show Extreme Stress .

The problem to consider is that many adjustable rate mortgages are based on LIBOR and if LIBOR is elevated when those rates reset, there is going to be a massive increase in foreclosures.

If the goal is to get LIBOR down, then I propose the following: Bank of America lends money to Citigroup who lends money to Wells Fargo who lends money to JPMorgan who lends money to Bank of America. We can have a big circle of all 9 banks forced at bazooka point to take money, to lend money to each other. LIBOR comes down and everyone is happy.

That is not a serious proposal of course, even though pretend lending makes far more sense than massive amounts of real lending.

Interview with Paul Kasriel

Long time readers have seen me refer to an Interview With Paul Kasriel , economist and director of economic research at the Northern Trust many times. The interview is from December 2006 but it is timeless. Here is one key snip, but if you haven't yet read it I suggest reading the entire article.

Mish: Would you say that consumer debt in the US as opposed to the lack of consumer debt in Japan increases the deflationary pressures on the US economy?

Kasriel: Yes, absolutely. The latest figures that I have show that banks' exposure to the mortgage market is at 62% of their total earnings assets, an all time high. If a prolonged housing bust ensues, banks could be in big trouble.

Mish: What if Bernanke cuts interest rates to 1 percent?

Kasriel: In a sustained housing bust that causes banks to take a big hit to their capital it simply will not matter. This is essentially what happened recently in Japan and also in the US during the great depression.

Mish: Can you elaborate?

Kasriel: Most people are not aware of actions the Fed took during the great depression. Bernanke claims that the Fed did not act strong enough during the great depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money but it did no good. More recently, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend which will severely limit money and credit creation.

Banks Unwilling To Lend

And so here we are. The Fed slashed interest rates to 1.50% and banks are unwilling to lend.

All the Fed and Treasury have accomplished so far was to put over a trillion dollars of taxpayer money at risk, and in doing so caused long term interest rates to spike up. This of course puts still more pressure on the housing sector. Someone needs to tell Paulson to go to hell but no one at the table had enough courage to do it.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

Click Here To Scroll Thru My Recent Post List

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

© 2008 Mike Shedlock, All Rights Reserved

© 2005-2012 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Comments