Oct

4

I was talking to my friend who is in 20 million dollars deficit on a major building project in Manhattan that is already under way. His story is that the first bank gave a promise for the money, then folded. The bank that acquired the other bank went forward and promised the money. Then it folded. This went on for a few rounds, and now he is hoping that following the bailout he won't go bankrupt together with all the contractors and workers that rely on this. Now multiply this by hundreds of thousands of projects across America and various industries… Another friend is a real estate broker, and was telling me that people are putting properties on the market at "sell at all costs" prices.

Here is the point of this post: I wonder, if the banks are going to do a "take the money and run" — how is the government making sure that the money is actually getting to the people who need it?

Kim Duncan replies:

The banks will sell assets to TARP and reduce their short-term borrowings (repo, Fed facilities, unsecured inter-bank borrowings) in order to reduce leverage. That will only marginally allow the recapitalisation that is required before banks begin to expand lending once again. We are in a credit contraction and TARP will not put an end to this process which could last years.

Your question is based upon a false premise. People who need the “money” (actually credit) are not necessarily the ones who deserve the credit. Is the project your friend trying to finance actually worthy of the investment? Required returns on investment are going up on everything since capital is scare, debt finance is contracting and asset prices are declining. The project will have to compete for its funding and its provision will not be based upon “need” but rather the risk-adjusted returns.

However, the other part of your question - “Take the money and run” is misleading. Banks will sell assets to the Treasury and reduce their borrowings. The Treasury will increase their borrowings by precisely the same amount which the banks reduce their borrowings. Leverage will be reduced in the banking system but the government borrowings will exactly offset. As a result, the same amount of cash freed up from lending to banks will be absorbed by lending to the government. As far as the banks are concerned, the lower leverage will not likely lead to lending capacity and hence the TARP will not, on its own, lead to new credit being offered to the private sector. The best that can be hoped for is that some price momentum of distressed assets will lead to an improvement in sentiment towards and between the banks thereby allowing the interbank lending and deposit markets to function. A first step, perhaps, but clearly no panacea.


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8 Comments so far

  1. Matt Johnson on October 5, 2008 12:19 am

    I agree, the banks will hoard the cash.

    Even if the money got to the people who 'need' it, it still may not help much. I mean, if you lose your job it doesn't matter how low your bills are, right?

    Here's what I see:
    - There are no guarantees that the housing market will stop falling – regardless of any bill.
    - Europe and the Pac-rim economies are slowing down.
    - The US dollar is strengthening which will decrease our exports and make us less competitive.
    - US interest rates may decrease BUT the ability to secure a loan has become more difficult.
    - People don’t know where to put their money, they're starting to get scared.

    So what might happen?
    - Company earnings begin to dive.
    - Companies begin massive layoffs.
    - Global equity markets continue to sell off.
    - The US dollar SOARS against all major currencies, at the beginning (now); only to reverse later.
    - It becomes all but impossible to secure a loan.
    - Highly leveraged banks, who had no idea how to manage risk, continue to go under. Remember we haven’t even heard about Europe yet, watch Spain…
    - Housing prices continue to plummet, only to reverse later.
    - People lose their homes and begin to hoard cash and gold.
    - Finally, they begin to lose hope…

    Yea, it’s bad out there, and it might get a lot worse.

  2. R P on October 5, 2008 9:00 am

    You came up out of the ether. Congratulations. You should have stood in bed. It’s easier.

  3. commenter on October 5, 2008 9:23 am

    How do banks make money - they lend. Banks are not going to take cash and hoard it. It’s like suggesting the automakers will get a bailout and hoard the cash.

    Cheap money may no longer be available and the banks may be more careful in how they make loans - but to suggest they will not provide liquidity doesn’t make much sense in my view.

  4. Dave on October 5, 2008 9:36 am

    Houses, condos and office buildings remain standing even after the bubble pops. We now have a real estate supply built for a 0% down world facing a “new” 20% down world.

    Oversupply means real estate prices will bottom at BELOW pre-bubble prices and will not bounce back for many, many years–perhaps over a decade.

  5. Anton on October 5, 2008 10:34 am

    Mr. Flam makes good points; this may be a self-reinforcing cycle, wherein a lack of credit promotes cash and hard asset hoarding. However, usually this behavior is exhibited on an individual rather than a corporate lender level. A more likely outcome is a renewal of the normal lender-borrower relationship. [Financial] corporations, those whose earnings are predominantly derived from credit creation, owe there existence to this relationship. They have a choice, positively wither and die if they don't put this available liquidity to use, or start lending freely again and have a chance at long-term survival. Unless the fed lowers bank-reserve requirements, the overall credit level will be reduced, since for a time the packaging and sales of loans will continue at a much lower level, causing a greater number of loans to be held on the lenders’ books. As this plays out, expect a short, sharp recession followed by slow sustainable growth.

  6. Anonymous on October 5, 2008 11:50 am

    Thanks for that. I'd personally been worried that the "money" grabbers might get away with the "credit". But now I know that isn't so, I'm reassured. Not to mention that your statistics post, which was otherwise very enlightening, seemed to confuse residual error with the regression coefficient. Or was I mistaken? Parkinson (1957) seems to fall rather on my side.

    A simple Brit.

  7. chris on October 5, 2008 2:29 pm

    The problem of people deserving money or not is misleading as well. How can a project be funded when the bank goes under? How can the borrower maintain credit and timely payments on obligations when the bank fails? This is the beginning of another cycle: the downward spiral of credit reports and personal and company credit. It just starts with one and the pricing for funds goes up exponentially if a business is left hanging do to a bank failure. They are then expected to pay much higher costs for funds and it constricts their margins. They cycle continues. It is extremely simplistic for the Wall Street brains and pundits to say this crisis occurred because people bought property they couldn't afford. It is arrogant and childish as well because those so call irresponsible buyers could likely have sold their home in time of need at a break even price if Wall Street would not have sold, resold, and resold the underlying assets while taking their cut each time. Wall Street has used the American mortgagee for their profit and now they are trying to blame the person who tried to buy a home for the going market price. WAKE up people! I am not at all for government intervention or bigger government but it is clear Wall Street behaves like unsupervised children in a candy store. Wall Street just happens to be in a money store instead and they can't or won't supervise themselves and the entire country has to pay for it. The bailout is really irrelevant because the people holding real estate are now expecting to pay 100 cents on the dollar for their mortgage while Wall Street is getting away with paying 25 cents on the dollar. It is a load of crap and one more twit that comes on TV trying to blame irresponsibility of the American consumer as the reason for a housing collapse needs to get smacked into reality. The only bubble left is the one in the head of most people on wall street and those mouths on TV that have proven by missing this entire market demise, that they are as much gullible as guru. Yet they are all so smart. How does that happen?

  8. Daniel Weber on October 5, 2008 4:11 pm

    In all the discussions I've read about "lack of credit", no one really seems to talk about interest rates. If capital is in such extreme demand, why then aren't interest rates rising to reflect this reality? It is discouraging to me that we seem to be moving towards a centrally controlled distribution of capital (socialistic), where "they" decide who does and does not receive capital. The determiner of who receieves funding should be bidding via interest rates. Until we see a return to sanity on interest rates (they're being held far below "market" levels now), we won't see any return to sanity in funding. Right now, whether or not you receive capital appears to be dependent on who you know, rather than the fiscal sense of the project. Of course, almost every project in the pipeline may be delusional and based on the economic realities of two years ago, in which case none of them should receive funding.

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