The Moral Hazard of Treasury's "Equity" Injection

Credit Slips blog ^ | 14 Oct 2008 | Adam Levitin

[Notary Sojac]

Treasury Secretary Paulson is jawboning banks to use the Treasury's capital injection to lend, rather than to just sit on the funds. This is very telling about the way Treasury sees the financial crisis and should concern us because it sets up a moral hazard and papers over the looming problem of the US economy: consumer overleverage.

Treasury is rightly concerned about the stability of financial institutions not for their own sake, but because of the crucial intermediating role they play in the economy. Treasury is "investing" (lending) money to the banks not just so that they will be stable, but in order to get them back into the business of intermediating between capital markets and borrowers in order to get the rest of the economy humming again.

The problem is that there might not be enough creditworthy borrowers and Treasury's "investments" (loans and guarantees) create a moral hazard. The banks are gambling with "other people's" (taxpayer) money. (And increasing FDIC insurance makes this problem worse). Banks have a chance to make great spreads--5% cost of funds, with lots of credit starved borrowers around who will pay major premiums (or have to workout defaulted loans). But a lot of the potential borrowers just don't look like good risks any more. Cheap funds, shifting of risk, and wild lending is what got us into this mess. And the equity injection combined with Paulson's comments looks like it is setting us up for a repeat.

Consider who banks might lend to. Consumers? Many are underwater on mortgages and auto loans and credit cards are teeing up for major losses. Business lending, perhaps, but how much distressed loan exposure does a bank want? And banks might lend to other financial institutions, such as hedge funds that are suffering from mass redemptions, but that's also high risk.

Obviously Treasury doesn't want to see a repeat of the current debacle. But the fact that it is engaged in a program that creates a moral hazard and is encouraging banks to lend, even if they think it is more prudent to sit on capital, points to the essential quandary of Treasury.

The US economy is fueled by consumer spending. In order for the economy to grow, consumer spending has to grow, and consumer spending is fueled by debt. Consumers largely spend not out of current assets or current income, but out of future income. Consumers are able to do this because of their assumptions about their current assets--especially their retirement savings. Unfortunately, consumer behavior for the past seven years has been shaped by the unrealistic expectations formed in a bubble. Consumers have saved less because they thought they had a bigger investment cushion. This sets us up for a retrenchment in consumer spending, which is exactly what Treasury does not want to see. In order to keep consumer behavior the same, Treasury needs to reinflate that bubble. But doing so just sets us up for another crash.

General consumer financial health would be helped by a shift to greater savings. But any shift will cause a short term contraction in consumer spending, which will mean economic pain for a while. This is a bitter pill to swallow. But it might not be as bad as the alternative, namely the economic effects of consumers becoming so overleveraged that we see massive defaults on all sorts of debts.

[Notary Sojac]

The last two paragraphs put it so well. What I’ve been trying to say for the last month ..... worded succinctly and dead on point.

[Travis McGee]

"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

-~~Ludwig Von Mises

[silverleaf]

excellent quote

[major-pelham]

gonna take a long while to wean consumers off of debt so it isnt really an option near term

some things that could make a diff seem to be massive business investment incentives like suspension of capital gains or business income taxes with time constaints - eg - if you invest this year you get 10 year tax holiday

i know its lefty clap trap but no one seems willing to just let folks take what they got coming

[o_zarkman44]

The feds can do what they want. But my personal agenda is to assume no more debt and consume only what is necessary, without going into further debt.

We can spend and borrow all we want. But that puts many people just a couple paychecks between solvency and losing the house. The promotion of irresponsible consumption by extenstions of credit is one of the main reasons we are in crisis. To compound that irresponsibility, much of our consumption is no longer made in America. We don’t have an ability to recapture and retain those assets in America when the assets are sent to China.

On the banking/government issue, is there any kind of expiration date on the directive? Will it require a congressional renewal or is it just an indefinite intervention? If it is the latter, we are witnessing the end of capitalism, free markets, private enterprise and ownership rights of the people. We must vehemetly insist that expiration provisions must be definitive in the banking intervention. Otherwise, we are in uncharted, dangerous territory that does not serve the people nor the Constitution.

[marshmallow]

Exhibit "A" is the $600 rebate most of us received earlier this year. The "stimulus" pacakage. It came with the explicit wish that we spend it in order to "stimulate" the economy. So this is what economic activity has come to in this country. Consumers buying goods which for the most part are imported.

Utterly ridiculous.

I banked my check and I wish everyone else had done likewise just to flip the middle finger at the Feds. Then again, they probably wouldn't have given us the $600 if they'd thought we wouldn't spend it.

[Travis McGee]

Here are some more with modern echos.

“Gentlemen, I have had men watching you for a long time, and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. I intend to rout you out, and by the eternal God, I will rout you out.”

~~President Andrew Jackson, on the 2nd National Bank

"The crisis of the abuses of banking is arrived. The banks have pronounced their own sentence of death. Between two and three hundred millions of dollars of their promissory notes are in the hands of the people, for solid produce and property sold, and they formally declare they will not pay them. This is an act of bankruptcy, of course, and will be so pronounced by any court before which it shall be brought. But cui bono? The laws can only uncover their insolvency, by opening to its suitors their empty vaults. Thus by the dupery of our citizens, and tame acquiescence of our legislators, the nation is plundered of two or three hundred millions of dollars, treble the amount of debt contracted in the Revolutionary war, and which, instead of redeeming our liberty, has been expended on sumptuous houses, carriages, and dinners. A fearful tax! if equalized on all; but overwhelming and convulsive by its partial fall. Everything predicted by the enemies of banks, in the beginning, is now coming to pass. We are to be ruined now by the deluge of bank paper, as we were formerly by the old Continental paper. It is cruel that such revolutions in private fortunes should be at the mercy of avaricious adventurers, who, instead of employing their capital, if any they have, in manufactures, commerce, and other useful pursuits, make it an instrument to burthen all the interchanges of property with their swindling profits, profits which are the price of no useful industry of theirs. Prudent men must be on their guard in this game of Robin's alive, and take care that the spark does not extinguish in their hands. I am an enemy to all banks discounting bills or notes for anything but coin. But our whole country is so fascinated by this Jack-lantern wealth, that they will not stop short of its total and fatal explosion."

~~Thomas Jefferson to Dr. Thomas Cooper, 1814

[Travis McGee]

[o_zarkman44]

Low interest rates not only encourage spending over saving, but the low interest rates provide such a narrow margin of profit for banks that they have to raise capital and fees from other transactions just to remain solvent.

Higher interest rates would not only improve bank revenues from loans, but would help retirement investments and CD rates. The Fed seems to be scared of higher interest rates because it would stop the debt financed spending and alleged growth of the economy. Since we don’t manufacture tangible wealth in tangible consumer goods, what keeps the money we spend in America turning in our economy? Nothing.

The spending spree is over. Time to pay up. Printing more money is not the answer.

[old curmudgeon]

Lots of good comments here, but everyone is missing the point.

The Fannie Mae Freddy Mac crisis was caused by exactly this same policy/theory.

That the banks should be forced by the government to lend money regardless of whether the banking industry considered those loans to be good business practice or not.

So now we are going to repeat this, not just in the housing market but across the entire financial spectrum?

Paulson and Bernake are no better than Barney Frank

[Notary Sojac]

I banked my check

I invested mine in Euros - in hindsight not the best choice I could have made, but still a decision I'd be happy to talk about to our masters in D.C.

[o_zarkman44]

Do you get the feeling like the Feds are trying to herd the people into doing things we feel uncomfortable doing? They expect us to reward bad behavior by sharing in the blame. Even though most of us have been responsible.

The best thing we the people can do is exactly the opposite of what the government “expects”. Do not borrow anything.
Do not spend anything beyond what is essential for your own personal welfare. Government is expecting increased tax collections to finance further defecit spending. The only way they can achieve those spending goals is to pump the economy for all it can extract. If we only support essential goods and services, government will not achieve those revenue goals to support it’s tax and spend extra policy. The only obvious goal our government has is to take what it needs to remain in power. It is up to the people who disagree with the current course of Democrat gifthorses to cut off those funds. Period.

We know who effed up the economy. We know who designed the policies that led to the bad debt. We know who promoted the policy. We know who knows who and how and why there has been negligence and criminal accounting practice. We expect prosecutions and demand accountability.

We do not want to reward failure. We don’t expect open ended investigations by the people who created the mess. We have to remove those responsible. That may be the biggest challenge because they are the ones throwing out the extortion money to buy votes.

[Moonman62]

He’s cut and pasted it a million times already.

[Moonman62]

The US economy is fueled by consumer spending.

It's actually driven by productivity that comes from investment and innovation. The demand side focus by the government and most economists is what gets us into so much trouble.

[silverleaf]

exactly my plan for an obama presidency

severely restrict my creation of wealth to what I need for my satisfaction ...as more benefits accrue to lower income level earners, look to join them at the trough

forego capital gains and forego putting effort into jobs or taxable enterprises that are excessively taxed - spend more time at nontaxable leisure

look for opportunities to become more self sufficient and tax avoidant, including coperative barter in the local economoy

become debt free to extent possible
paying off debt on tangibles like the house and car, may be better than saving dollars that are going to be increasingly devalued, in institutions subject to federal monitoring and intrusion

for every dollar in increased obamataxes, fees etc refuse spending 3 in the economy

[major-pelham]

Perhaps but I think banks just always work on a 4% net spread - cost of funds v. interest rates charged. I think they arbitrage rates regardless of where they are. OTH, low rates do disourage savings (the why bother effect) as does inflation, but high ‘real’ rates do encourage it. And you are right the spree is over, poor cash flow and fear of the future have taken care of that.