Will Banks Lend, or Hoard, the Treasury's Money?

Treasury Secretary Paulson put $250 billion into banks to loosen the credit markets. Is that making loans easier to get?
SunTrust says it will make "prudent" use of its capital infustion Chris Rank/Bloomberg News

You can't ask for faster service than this: On Oct. 3, Congress reluctantly approved the $700 billion bailout bill. Ten days later, Treasury Secretary Henry Paulson decided to use the first $250 billion of that money to inject new capital into the banking system. By the end of October, the first slug of government money was on its way to some of the biggest banks in the country.

But despite the quick infusion of new funds, bankers are signaling that prudence may rule, so they may not be willing to lend as much as hoped. For example, James M. Wells III, chief executive of SunTrust Banks (STI), which will receive $3.5 billion from the government, said in an Oct. 27 statement that "as long as the current uncertain and challenging economic environment persists, maintenance of capital at elevated levels is desirable."

Politicians and regulators responded by warning banks that they had to step up to the plate. In an Oct. 28 speech, Anthony W. Ryan, acting Treasury Under Secretary for domestic finance, admonished financial institutions: "As these banks and institutions are reinforced and supported with taxpayer funds, they must meet their responsibility to lend."

The big issue is whether the combination of government money and heavy-duty jawboning will boost bank lending. Let's take a look at some of the key questions:

Have banks stopped lending?

Actually, no. Large commercial banks expanded their outstanding loans by almost $200 billion, or 5%, in the four weeks ended Oct. 15, a period that included the passage of the bailout bill. That's after doing little net lending in the first eight months of the year. Small banks showed a much smaller 1.5% increase in loans over the same four-week period.

True, given the extreme market and economic turmoil, these increases may be somewhat misleading. For example, some of the additional lending probably represents corporations drawing down already-existing bank credit lines, rather than banks actually extending new loans. Nevertheless, the increase in bank loan portfolios is a step in the right direction.

So why the worry?

The same data show that even while large banks were adding to their loans, they were also socking away $88 billion in cash. That leaves Washington concerned that any additional infusions of money will also be tucked away by the banks, to be used to fund acquisitions or to cushion more losses.

So far, however, the real slackers seem to be U.S. operations of foreign banks, which are not included in the capital injection program at this point. Over the past four weeks, they've added $68 billion to their cash stockpiles while barely increasing their lending at all.

Why are some bank executives expressing caution about using the federal money for more lending?

In large part, the bankers are managing expectations. Under ordinary circumstances, a $250 billion increase in equity capital might translate into an enormous, $3 trillion increase in lending, since banks typically make more than $10 in loans for every $1 in capital.

But given the slowing economy and the continued fall in home prices, they will need much of the government money simply to counteract almost-certain future losses on existing loans. "The $250 billion is probably about enough to plug the hole in the aggregate bank balance sheet from losses that have yet to be recognized," says Jan Hatzius, chief U.S. economist at Goldman Sachs (GS).

What did Paulson expect to get from the big outlays?

First, he was hoping to avoid an actual contraction of bank loan portfolios, a likely outcome without government intervention. That is, facing the prospect of big losses on mortgages and other loans, bank executives would almost certainly have pulled back on lending. In addition, banks are under pressure from both investors and regulators to be more cautious. The combination could have reduced lending by $500 billion or more, which would have been an economic disaster.

Paulson's big investment dramatically reduces the odds of such a contraction, for both economic and political reasons. Not only does it give the banks more money; the huge government stake also publicly puts both bank executives and regulators on notice that the banks are expected to lend more, not less. Indeed, John C. Dugan, comptroller of the currency and one of the main overseers of the banking system, recently told his managers that they have to be "careful not to overreact and make problems worse by acting too precipitously or being more stringent than we need to be."

What would count as success for the bailout program?

From 2004 to 2007, the height of the credit boom, commercial banks averaged about $600 billion per year in net new lending. To achieve the same lending expansion over the next year is probably unachievable, given the weakness of the economy.

More realistic would be net lending of about $350 billion. That would expand the loan portfolios of commercial banks by about 5%, or faster than business investment and consumer spending is likely to grow over the next year. To go above that level would almost certainly require a return to the ultra-loose lending standards that landed us in the soup to begin with.

Would $350 billion in new bank lending provide enough credit to avoid a deep recession?

No. The problem is that commercial bank loans account for only about 30% of total lending to households and nonfinancial businesses. Even if commercial banks expand their portfolios, other parts of the financial system, such as corporate bonds and asset-backed securities, are still frozen—and the banks can't make up for that. Banks simply don't have the central role in the financial system they once had.

Should Treasury force the banks to lend more, given the market woes?

The government can probably get better results in the short run by working through Fannie Mae (FNM) and Freddie Mac (FRE). The two mortgage lenders, which have been controlled by the new Federal Housing Finance Agency since early September, have a mortgage portfolio of about $5 trillion. That's comparable in size to the $7 trillion in loans for all commercial banks, giving the government enormous leverage to boost mortgage lending if it wants. So far, however, there is little evidence that the feds are juicing up Fannie and Freddie.

Helping distressed homeowners stay out of foreclosure should also be high on the agenda. The Treasury and the Federal Deposit Insurance Corp. are working on plans to guarantee troubled loans in exchange for lenders reducing payments.

Are there any potential pitfalls in the bailout program?

Several. Politicians and regulators will have to decide whether it is right for the banks receiving the bailout money to continue paying big bonuses and dividends. And if home prices continue to fall, the banks may need even more money—and they'd better be able to show they made enough new loans to justify the first $250 billion.

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