Will the Banks Lend?

The NYT’s lead headline this afternoon is unambiguous: "Treasury Chief Says Banks Must Deploy New Capital". But in 2,300 words of reporting, reaching as far as a run on the Hungarian currency, this is the only mention of any requirement for US banks to start lending:

“The needs of our economy require that our financial institutions not take this new capital to hoard it, but to deploy it,” Mr. Paulson said.

That’s it. Paulson’s expressing a preference here — and he’s got a strong bully pulpit. But he’s not taking a voting stake in the banks, he’s not taking any board seats, and ultimately, if the banks’ shareholders will be better off hoarding money rather than lending it, that’s what the banks’ executives are going to do.

I was at a lunch today with Chris Wallace of Vaughan Nelson, a fund manager who’s been following the credit markets closely. So far, neither he nor any buy-side investors he knows in the fixed-income markets are buying credit: "we’re in a secular bear market for all risk assets," he said, and that means that any loans banks extend today have a good chance of being marked down tomorrow. They have huge exposures already, and are in the process of deleveraging: the new capital will help them bring their capital ratios up if they don’t go ahead and lend it out.

Lending Treasury’s funds, on the other hand, is a risky thing to do heading into what might well be the worst recession of the post-war era. Wallace anticipates real consumer spending falling by 10%, and homeownership rates falling by 4 percentage points; those kind of changes could devastate companies’ abilities to repay their loans.

Remember too that even a generous tier-1 capital ratio of 10% implies 10x leverage: a bank which receives $25 billion of new capital can use it to make $250 billion of new loans. You don’t need very many of those loans to go bad before you start eroding your capital base even further.

America’s banks — and the world’s, for that matter — have had de facto unlimited access to very cheap Fed liquidity for many months now. That hasn’t induced them to lend. Will this latest recapitalization do the trick? I’m far from convinced. And what’s more, the demand for loans is drying up fast: do you really feel like buying a bigger house right now, or taking out a car loan? Well, businesses are in the same boat. In a recession, their ROI falls, so they borrow less.

With less demand for money, and no real desire on the part of the banks to lend it out, I think it’ll take more than hand-waving statements from the Treasury secretary to get the credit markets moving again. I do hope that Paulson is looking one step ahead here, and coming up with ways to compel the banks to lend — even if they don’t particularly want to.

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