Why Bank Bailouts Have Failed

Banks and People (part 3 of 3)

At the start of the crisis, the U.S. government said it wanted banks to switch from making investments back to making loans, loans that were sorely needed by businesses and consumers. Now, with TARP about to end, President Obama is still saying the same thing.

The US government estimates it will make a profit of $19 billion from the big banks it bailed out, but laments that the banks are not using bailout money to make loans. Sheila Bair, head of the FDIC, was particularly critical of the government’s TARP bailout program, noting that bank loans declined by 2.8% in the last quarter, the biggest decline since 1984, the year the FDIC began tracking bank loans.

The pairs of four variables in my previous post,  “Part II of Banks and People,” show why this is happening. During the financial crisis  banks eschewed making bank loans to customers (options C and D) in favor of  selling their own stock and bonds along with making short- and long-term investments in government and corporate bonds (options A and B).

The Role of Government

The US government has only itself to blame for its disappointment with banks not making loans. The Fed has encouraged bank investment by keeping bank-to bank (Libor) interest rates low. Because of the government’s low interest rates, banks can borrow cheap from the Treasury and make higher and safer returns through investing in government and corporate bonds than by making loans and/or by paying higher interest on customer deposits.

Another reason banks aren’t making many loans is the terms of the government’s bailout of big banks in programs such as TARP, and in particular, the government’s mandate for lower bonuses for bank executives. Bank executives want out of these programs quickly. And the government is encouraging them to do this. The government is letting big companies such as Bank of America, Citigroup, and Wells Fargo prepay government bailout assistance. This doesn’t encourage banks to make loans either.

Bank of America sold stock itself to raise $19 billion. Wells Fargo wanted to wait and raise money from business profits, but it’s been pressured to sell stock too. It just raised $10.4 billion by selling new shares in itself to pay back half of its loan from the US government. Blocks to Citigroup’s request to repay TARP funds have been removed by the IRS. and it will pay back it’s entire $20 billion debt through sales of its shares. Meanwhile the FDIC has guaranteed $300 billion of bank-issued bonds.

As you can see from the Liquidity and Solvency of Banks table in Part II of this blog series, neither selling bank stock nor selling bank bonds (options A and B) increases these big bank’s solvency. Selling shares and bonds only increases liquidity and leaves the banks still in debt. Meanwhile, on the other side of the banking coin, the “People,” are suffering. Business failures, foreclosures, and layoffs are continuing to rise. Unemployment in Detroit hit 50% this week.

And while banks pay off TARP rather than make loans to consumers, piles of affluent people’s cash invested in money market funds have nowhere to go. This bank-related problem is severely impacting no- and low-earned income people (including many retired people).

Money market funds rely on short-term “securitized” investments. These kinds of short-term investments, packaged and sold by banks by combining consumer loans (loans for cars, mortgages, and education), began to become unsellable beginning in 2007. The Fed has bought $1 trillion of mortgage-backed securities from banks. But the securitized investment market dried up. As a result, money market funds shifted into investing in short-term (weeks to a few months) government bills called Treasury bills.

People and businesses and other organizations, such as condo associations, who depend on Treasury bills for a fixed income are now out of luck. Because of the huge influx of demand for T-bills on the part of money market funds, interest rates on T-bills are almost as low as the pittance usually paid on money market funds themselves. Money market funds serve large investors who “park” uninvested cash in them. The funds have to pay some kind of interest on deposits, and T-bills are their only choice these days.

Only the US government could be remotely happy with this dismal turn of events. It’s getting lots of money out of sales of Treasury bills (and Treasury Bonds) as well as from big banks’ repayment of TARP loans.

Smaller banks, however, have received almost nothing from TARP or from the FDIC’s program that encouraged big banks to make short-term loans to businesses and consumers. The FDIC’s bank loan guarantee program ended last month, small and mid-size bank failures this year topped 130, and bank loans just dropped by a record amount.

As a result of government policies, big banks are still making profits, but cash isn’t trickling down to smaller banks. They’re failing daily. Nor is cash flowing into the economy. Smaller banks and businesses and individuals, particularly lower-income people, are obviously coming out with the short end of the stick.

A Split within Government

The FDIC and the rest of the U.S. Government do not seem to be in synch while trying to solve the “banking problem.” For example, a recent study shows that 60 million adults in U.S. households lack bank accounts. These people use check cashing services and keep their money on hand. They have no relationship with banks.

The FDIC is researching ways to get these people into the banking system, a goal that would bring “real” cash into banking system.

The FDIC is also scrambling to keep failing banks’ deposits “liquid” and “solvent” by transferring them to other banks. And the FDIC continues to guarantee transfer of toxic assets of banks onto the shoulders of solvent banks, hedge funds, and other buyers who can hold these assets long enough to [hopefully] recoup their purchases and make a profit. In short, the FDIC is pushing banks towards doing the business of banking on behalf of the people.

The Fed, the Treasury Department, and Congress, on the other hand, in the name of “prevention” of another financial crisis, are pushing banks towards raising capital reserves. And now the government is allowing banks to deplete their capital reserves by using them to pay back TARP loans early.

Over the objections of the FDIC head and securities analysts, the US government is driving big banks (and large companies such as GM) to raise a lot of money quickly, even if that’s at the expense of the banks’ capital reserves and their customers. These banks, and especially Citigroup, have put themselves in a precarious place by paying back their government loans early. As a result, TARP has failed the both the banking system and the people.

A Suggestion

The government needs to pay more attention to bank solvency along with bank liquidity. More investments in and by big banks aren’t going to solve our “banking problem.” It’s way past time for government to give the “people,” a break.

I would strongly suggest that The Fed, The Treasury, and Congress think harder about ways to encourage all banks to focus more on bank customers again. In fact, it might even be a good idea for government to consider supporting credit unions, check cashing services, and other institutions who do make loans to business and consumers.

Copyright © 2009 Nancy K. Humphreys

Postscript:
If The Liquidity and Solvency of People table in Part II of this series interests you or the ones you care about most, I highly recommend Robert Kiyosaki’s Rich Dad Poor Dad book series or games for yourself or a gift.