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The Moral Hazard of Treasury's "Equity" Injection

posted by Adam Levitin

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.


But the 64K question still remains. To whom or to what sector would banks lend this $250B in new capital? Do you think JPM would take a call from GM to borrow several billion? Me thinks not...

But rejoice, today was a great day to be a banker and not just because of the largess bestowed upon them by the Hammer. Let's look at the preceding week that caused led to the "nationalizing" of the banks.

1. More policy "entrepreneurs" started to focus on the TED spread, which is the difference between LIBOR and the three month T-Bill. Of course, during the past week, the spread spiked, which was taken to mean that credit was "frozen." In my opinion, reliance on the TED is not an effective barometer in this current environment; heck, the British Bankers Association admitted that it had been gamed during the past several years. Back on point, LIBOR only makes sense when member banks are dealing with a Bagehotian central bank; i.e. the central bank, functioning as a lender of last resort, requires near-cash collateral and *punitive* interest rates. To avoid these onerous terms, banks would instead borrow from each other (voila LIBOR). Fortunately for the member banks, the Federal Reserve (albeit with some prodding by Congress) has been more than willing to accept almost anything as collateral through their various lending windows. Why borrow from each other, if you can just borrow from the banker's bank? So, if the banks are lending to each other at all, why should LIBOR increase? Would it be because of trillions of dollars in commercial loans and mortgages are set via LIBOR?

2. Compounding the TED spread spike last week were reports that many of the larger banks arbitrarily increased margin requirements to many hedge funds, resulting in forced liquidations. Appreciation of the yen further exacerbated the problem, forcing many hedgies to unwind their yen carry trades.

These factors, among others, created a bear market within a bear market, hammering the message home to policy makers and Main Street alike: Wall Street needed a bailout and it need it fast. And so we've had TARP and now, the partial "nationalization" of Wall Street.

While I'd like to believe that conspiracy theories and manufactured crises don't exist, I would also like to believe that evidence wasn't manufactured in Iraq and that commodities speculation didn't exist this past summer.

Finally, someone has pointed out the flaw I have been thinking about before this debacle even hit the front pages - you can't become rich based on borrowing or maintain prosperity. The fact that raising incomes is not even brought up in polite company speaks volumes about our situation.

I agree, the hysteria surrounding the TED spread was ridiculous. Especially since a lot of the cause of the spread increasing was that the treasury rate was declining, rather than the commercial paper rate increasing. According to Bloomberg, the annual rate of 3 month paper was around 3.6% for AAA borrowers when the FED started its 'emergency' program to lend money to prop up the commercial paper market. In what world is having to pay 3.6% interest rates an emergency? The cost of inflation is probably higher than that. Someone else claimed that the fact that IBM (I think it was IBM) had to pay around 8% for a 10 year loan was further horrifying proof of a functionally frozen credit market. Huh? Even if the credit risk was zero, a rational person would be reluctant to lend at much less than that simply because of inflation risk.
The only REAL frozen credit markets are the ones associated with lending to banks. And with the games that banks have been playing with their balance sheets, no rational person should be willing to lend to them except at rates comparable to high yield bonds.

If someone has lived beyond his means, he will have to cut back on spending. At some point in time. Either voluntarily or because others simply refuse to lend him more money. And he had better change his spending habits as soon as possible. It's as simple as that. Any notion that overspending is somehow beneficial to the economy (or patriotic, or whatever is seen as positive) is, in the long run, ridiculous.

I admire the high quality of the posts and comments on this blog site. I read Roubini, Naked Capitalism, Calculated Risk, and a few others. This site seems as good if not better than most of them. Of course I am not an economist -- but, then, who is, really?

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