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The Paulson Plan: Compelling Banks to Lend at Bazooka Point

by: Michael Shedlock October 15, 2008 | about stocks: BAC / C / JPM / WFC

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For now, you can force banks to take money, but you can't force them to lend it. Let's explore this theory starting with a look at the Drama Behind a $250 Billion Banking Deal.

The chief executives of the nine largest banks in the United States trooped into a gilded conference room at the Treasury Department at 3 p.m. Monday. To their astonishment, they were each handed a one-page document that said they agreed to sell shares to the government, then Treasury Secretary Henry M. Paulson Jr. said they must sign it before they left.

The chairman of JPMorgan Chase (JPM), Jamie Dimon, was receptive, saying he thought the deal looked pretty good once he ran the numbers through his head. The chairman of Wells Fargo (WFC), Richard M. Kovacevich, protested strongly that, unlike his New York rivals, his bank was not in trouble because of investments in exotic mortgages, and did not need a bailout, according to people briefed on the meeting.

But by 6:30, all nine chief executives had signed — setting in motion the largest government intervention in the American banking system since the Depression and retreating from the rescue plan Mr. Paulson had fought so hard to get through Congress only two weeks earlier.

What happened during those three and a half hours is a story of high drama and brief conflict, followed by acquiescence by the bankers, who felt they had little choice but to go along with the Treasury plan to inject $250 billion of capital into thousands of banks — starting with theirs.

In addition to the capital infusions, which will be made this week, the government said it would temporarily guarantee $1.5 trillion in new senior debt issued by banks, as well as insure $500 billion in deposits in non interest-bearing accounts, mainly used by businesses.

All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks. The latest show of government firepower is an abrupt about-face for Mr. Paulson, who just days earlier was discouraging the idea of capital injections for banks.

Compelling Banks to Put New Cash to Work

Bloomberg is reporting Paulson Lacks Leverage to Compel Banks to Put New Cash to Work:

Treasury Secretary Henry Paulson persuaded nine major U.S. banks to accept $125 billion in government investment. Getting them to lend it out may prove a tougher sell. [Mish note: The other $125 billion goes to hundreds or thousands of smaller banks]

"The truth of the matter is, they can't put a gun to their head and say you have to lend this money," said Charles Horn, a former official at the Office of the Comptroller of the Currency, part of the Treasury Department, and now a partner at the Mayer Brown law firm in Washington.

Treasury officials acknowledge they can't force banks to get the taxpayer money into the hands of their customers. Instead, officials are betting that the government's investment will create conditions where banks have a greater incentive to earn profits from lending than to hoard money to shore up their balance sheets.

"It's in their economic interest," said David Nason, the Treasury's assistant secretary for financial institutions, in an interview with Bloomberg Television.

Bazooka Theory

There seems to be a fine line between ...

1) Illegally forcing supposedly well capitalized banks at bazooka point to take money on questionable terms

2) And illegally forcing those same banks at bazooka point to lend it

Self Preservation

I hope that fine dividing line holds and I also hope banks do the responsible thing (nothing) because Paulson is acting like a complete fool. It is in no one's best interest to lend that much money. We are in this mess because banks lent money to anyone and everyone including those with no possible means of paying the money back.

The US is in a recession, consumers are cutting back discretionary spending, there is rampant overcapacity in every sector but energy, and there is no reason to go on a lending spree. Furthermore, there is no reason for any qualified buyer to want to borrow. Why would any responsible party want to expand in this environment? The only people who want to borrow significant sums of money now are the very people banks should not want to lend to.

Thus the best thing banks can do with that money is sit on it. Yet the penalty for sitting on it is the difference between what the Fed will pay on bank reserves and the 5% interest banks have to pay at bazooka point for borrowing money they did not want in the first place. If banks do start lending like Paulson wants, defaults are guaranteed to increase dramatically.

Pretend Lending And LIBOR

LIBOR is based on rates for bank to bank lending. That lending is simply not happening as noted in

LIBOR and the TED Spread Still Show Extreme Stress

The problem to consider is that many adjustable rate mortgages are based on LIBOR and if LIBOR is elevated when those rates reset, there is going to be a massive increase in foreclosures.

If the goal is to get LIBOR down, then I propose the following: Bank of America lends money to Citigroup (C) who lends money to Wells Fargo who lends money to JPMorgan who lends money to Bank of America (BAC). We can have a big circle of all 9 banks forced at bazooka point to take money, to lend money to each other. LIBOR comes down and everyone is happy.

That is not a serious proposal of course, even though pretend lending makes far more sense than massive amounts of real lending.

Interview with Paul Kasriel

Long time readers have seen me refer to an Interview With Paul Kasriel, economist and director of economic research at the Northern Trust many times. The interview is from December 2006 but it is timeless. Here is one key snip, but if you haven't yet read it I suggest reading the entire article.

Mish: Would you say that consumer debt in the US as opposed to the lack of consumer debt in Japan increases the deflationary pressures on the US economy?
Kasriel: Yes, absolutely. The latest figures that I have show that banks' exposure to the mortgage market is at 62% of their total earnings assets, an all time high. If a prolonged housing bust ensues, banks could be in big trouble.

Mish: What if Bernanke cuts interest rates to 1 percent?
Kasriel: In a sustained housing bust that causes banks to take a big hit to their capital it simply will not matter. This is essentially what happened recently in Japan and also in the US during the great depression.

Mish: Can you elaborate?
Kasriel: Most people are not aware of actions the Fed took during the great depression. Bernanke claims that the Fed did not act strong enough during the great depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money but it did no good. More recently, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend which will severely limit money and credit creation.

Banks Unwilling To Lend

And so here we are. The Fed slashed interest rates to 1.50% and banks are unwilling to lend.

All the Fed and Treasury have accomplished so far was to put over a trillion dollars of taxpayer money at risk, and in doing so caused long term interest rates to spike up. This of course puts still more pressure on the housing sector. Someone needs to tell Paulson to go to hell but no one at the table had enough courage to do it.

Should We Abolish Credit Rating Agencies? Jan 06, 2009
Acuity Brands, Inc. F1Q09 (Qtr End 11/30/08) Earnings Call Transcript Jan 06, 2009
As Lending Ebbs, Excess Reserves Flow - A Lot Jan 06, 2009
How Are Banks Spending Bailout Money? Anyone's Guess Jan 06, 2009
Netting Derivatives: Slippery Slope Marred by Opaqueness Jan 06, 2009

Related Stocks:

BAC, C, JPM, WFC

This article has 20 comments:

Oct 15 10:53 AM
WHO WHO Are The Banks Suppose to Lend to ?? The Same people who they just forclosed on 6 months ago. Or People with NO jobs or bad credit or deep in credit card and car loan debt ? Who ?? Busniesses who now have very few customers . People who are doing OK , Dont want to borrow money NOW ! At High Interest rates or low interest rates for that matter.
Paulson and company are just stalling till Jan , when they can LEAVE . They GOT there Cash and the American Public is left Broke and Holding the bag. When Obama and Dems take control in Jan they'll finnish off whats left of American businesss with New Punishing Taxes on Business and the wealthy , but that wont be enough so they'll start on the working man by 2009 everyone who works will pay much higher taxes. This of course will take whats left of the American economy and destroy it. Depression will follow I was raised in the 1930s it wasnt much fun but I was a little kid so it wasnt too bad , I'll me a Old Man in this depression. Kinda scary
God Help America
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Oct 15 11:02 AM
Isn't WFC on record saying they were going to raise 20B in new capital to support the Wachovia 7B stock acquisition? This seems cheaper and less dilutive than what their other options were.
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Oct 15 11:39 AM
OK. I'll step up to the plate and borrow the entire $125 Billion. It will be a lot of work to spend it all, but I'll do my best and take one for the team.

As long as the repayment plan doesn't exceed $1/month I can make it work.

Who do I contact to get the paperwork started?
Reply | Link to Comment
Oct 15 11:51 AM
Every year millions of new people join the labor force. Many of them a few years later want to buy a new home or new car. But none of them are worth loaning to?

All business equipment and structures has a finite life. After which it has to be replaced (and there is also much equipment which still works but is worth replacing because of lower operating costs, more capabilities). But companies doing this are not worth loaning to?

There are always areas of business which are expanding. (in bad economic times these are counter-balanced by declining areas). These expanding areas of business are not worth loaning to?
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Oct 15 11:54 AM
Why wouldn't the banks lend to those just foreclosed upon? We have a Secretary of the Treasury who skipped town just before what he helped set up hit the fan. I would say both are adept at taking the money and running.
But it bothers me that he didn't blow the whistle some time much earlier. Perhaps as long as his buds were getting the big bonuses everything was fine. I can't imagine that he has a conflict of interest. Its also surprising that the one bank that made a squawk about forced government intrusion is one of those flaky West Coast banks and not a part of the NY East Coast sophisticated elite.
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Oct 15 12:17 PM
Past Tense:

With a tapped out consumer and a slowing economy most businesses are going to be hunkering down. The first item that shrinks after slowing sales is the bottom line.

If profit shrinks too much the business goes under and the game is over. Prudent businesses will put off purchases or upgrades until the effect of the slowdown is known and revised plans can be made. Once that loan is taken the payment becomes a long term burden that claims just that much more of the company's working cash.

Even loans for new equipment that generate savings in operations are a burden if the necessary volume for realizing those savings doesn't materialize or if they are too small. While saving $1000/month over 30 years is great, what if the loan payment is $3000/month for 5 years? It may be good in the long run, but first you have to survive that first 5 years in an environment where income is shrinking and your monthly expenses are $3000 higher.

Businesses without a very large cash cushion will be looking to cut costs first and foremost just to make sure they can survive until conditions improve. They won't be looking for many loans.

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Oct 15 04:24 PM
Once upon a time, there was a mouse in a maze.
It was a very clever mouse and the maze was very big.
Unfortunately, the maze had no exits.
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Oct 15 04:52 PM
And the mouse lived un-happily ever after,
loathing the builder of the maze.

The End
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Oct 15 05:01 PM
Maybe that mouse, but this mouse decided that life could not possibly suck that much and looked for alternatives. He sought and behold, he found.

"I look on the faithless with loathing, for they do not obey your word."
Psalm 119:158
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Oct 15 05:08 PM
Those who choose to ignore the wisdom found throughout Proverbs usually wind up regretting it.

If our country had not done so (in aggregate) we would not be in anywhere near as big a mess as we are in now.

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Oct 15 06:07 PM
"How did this happen? Who's to blame? Well certainly there are those who are more responsible than others, and they will be held accountable. But again, truth be told...if you're looking for the guilty, you need only look into a mirror.
I know why you did it. I know you were afraid. Who wouldn't be? War. Terror. Disease. There were a myriad of problems which conspired to corrupt your reason and rob you of your common sense. Fear got the best of you and in your panic, you turned to the now High Chancellor Adam Sutler. He promised you order. He promised you peace. And all he demanded in return was your silent, obedient consent." V
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Oct 15 06:53 PM
"V", you the man. However, it is almost all the fault of the fractional reserve bankers abetted by the governments they bribed with fiat money. They have financed wars, caused depressions that led to more wars and socialism, and social decay. I blame them for everything from WWII, Communism and Fascism to the teacher's unions and the repulsive tatoos I see everywhere.

Who would guess that violating just the lying and theft Commandments would cause such misery?
Reply | Link to Comment
Oct 15 08:31 PM
THE BANK TAKE OVERS HAVE BEEN A PLANNED EVENT !!!!

THE SUBPRIME LOAN CRISIS A PLANNED EVENT !!!!!!!!

SPITZERS BLEW THE WHITLE ON IT AND THEY COVERED IT UP !!!!!!!!!!!!!!!

www.washingtonpost.com...
Reply | Link to Comment
Oct 16 11:48 AM
James Wilson,

How can you be so crass as to suggest our governmnentr is corrupt?? The congress is filled with men of superior character and high moral standards who always look out for the best interests of the American people!

And if you believe that I have some waterfront property in Arizona I would like to sell...
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Oct 16 12:12 PM
Crass?

I believe it would take years of concerted effort for most Congress-critters to improve their morals to the level of 'crass'.
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Oct 16 01:01 PM
Smarty pants,

I appoligize to all "crass" for slandering them by insinuating they were like congress.

"Reader, suppose you were an idiot, and suppose you were a member of congress. Oh, but I repeat myself." - Mark Twain
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Oct 16 02:08 PM
"Thus the best thing banks can do with that money is sit on it"

"And so here we are. The Fed slashed interest rates to 1.50% and banks are unwilling to lend"

Talk about self-fulfilling prophecies. Now we have self-fulfilling conclusions before the money has even changed hands. Maybe someone needs to tell Shedlock to go to hell and take his cut-and-paste articles with him.
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Oct 16 05:00 PM
Problem is low interest rates. If a bank's spread between his cost of borrowing and what he charges on loans is, say 2% (as it has been on HELOC's et..), then his profit after expenses and overhead is just 1%. This means that if just 1 borrower out of 100 defaults compeletely, the bank loses all the profit from the other 99 who pay in full.

The reason banks cannot lend is that there are few creditworthy borrowers left, and the default probability on those who would like to borrow exceeds the profit that banks can get from the spread.

Bring back reasonable interest rates, i.e. 2-3% points above inflation, and the economy will eventually fix itself. the notion that a truly viable project would not be financed unless interest rates were below inflation is self-evidently incorrect. It is also self-evident that sustained interest rates below inflation would mathematically drive asset prices towards infinity, as has been demonstrated empirically by recent events.

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Oct 31 12:07 PM
When things are going up, credit scores can automatically improve just because asset prices are going up. Vice versa, when asset prices are going down, credit scores can automatically drop. Take debt out of the system as a driver of growth (BY TAKING AWAY THE GOVERNMENT'S COVER-UP OF THE INHERENT FRAUD OF FRACTIONAL-RESERVE BANKING) and the whole system calms down.

It is not the banks that were stupid. We are the stupid ones for leaving in place a system that systematically allows banks to steal our accumulated wealth.

The problem is that we pay trillions of dollars (government and personal) to do what we could easily do for ourselves ABSOLUTELY FREE: that is, to supply ourselves with money to exchange with each other and with workers in other countries.

Replace the Fed dollar with our own money, put it into circulation via equal-dollar distribution=End of Depression.

Replace the FederaI Income tax with a flat, one-half percent electronic transfer fee (and get rid of all corporate and personal subsidies and 4000 Federal laws), and the next 200-year boom will start.
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Oct 31 12:17 PM
Give any money "to the banks" by FIRST GIVING IT TO LEGAL U.S. RESIDENTS (VIA EQUAL-DOLLAR AMOUNTS, similar to how the 2008 Economic Stimulus checks were handed out) and MAKING THE BANKS EARN IT BY GETTING TRANSPARENT AND MAKING LOANS.

If we let the MARKET work, it will pick the right banks to help out:THE ONES THAT ATTRACT OUR DEPOSITS. The rest need to die. We don't need 6 bank branches on every block.

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