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Let the Bank Bailout Work

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By Martin Neil Baily and Charles L. Schultze
Thursday, January 15, 2009

Last week, a five-member congressional oversight panel harshly criticized how the U.S. Treasury has so far spent the first $350 billion tranche of the Troubled Asset Relief Program (TARP). The bulk of that money has been used to inject capital into a wide range of potentially viable but ailing banks, giving the government an ownership share in return for these funds. The panel had several complaints about the way TARP has been run, but its basic criticism -- widely held among members of Congress and the public -- was that the Treasury has not required the banks to use the money for increasing loans to business and consumer borrowers.

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These findings have strengthened a growing interest in Congress to condition approval of the program's remaining $350 billion on a mandate that the Treasury not only track the funds but also require that they be used primarily to make new Main Street loans -- to support homeowners facing mortgage defaults, struggling municipalities and other troubled segments of the economy.

The criticisms behind this sentiment are misguided. For one thing, the position of banks is dire, and lending is almost sure to contract even if TARP is fully successful. Furthermore, while "following the money" might seem like the right thing to do in terms of accountability and oversight of federal tax dollars, it is actually infeasible because bank loans typically cannot be traced to a particular source of funds -- banks get their money for loans from a variety of sources, such as borrowing from other financial institutions and government or through private injections of new capital.

Much of the criticism of TARP reflects a fundamental misunderstanding of the basic financial problem that the program was intended to address. The first goal was to ameliorate the large and long-lasting contraction in lending that was the inevitable consequence of the mortgage-related losses by U.S. banks. This credit squeeze has already depressed bank lending and, if unabated, threatens to radically deepen and prolong the recession. It is unrealistic to expect troubled banks to make a lot of new loans. Only when the banks are stabilized can we expect them to raise new private capital to expand lending and fuel an economic recovery.

Look at the facts and the numbers: An International Monetary Fund analysis in October found that global banks and other lenders are likely to suffer losses of about $1.4 trillion from defaulting U.S. mortgages and consumer and corporate debt. (About half of that total is mortgage losses.) These losses, once recognized on the books of financial lenders, reduce their capital by an equal amount. That capital is the "backup" behind a lender's overall portfolio of loans and other investments. In the United States, each dollar of lender capital supports, on average, more than $10 in loans and other assets; the "leverage ratio" varies among different institutions and different kinds of assets.

Bank supervisors, following a complicated set of regulations, are charged with keeping bank capital from falling and remaining below a "safe" level. If a bank's capital does dip below certain levels, the bank is required to limit its lending. Equally important, as its capital falls relative to its assets, the bank would be considered increasingly risky by private markets, raising its cost of borrowing, lowering its stock price, and reducing its ability to attract new capital and expand its loans and investments. In short, for every $1 million of losses on bad loans, a bank must reduce its portfolio of loans by around $10 million, unless it can obtain new capital to offset the losses. Unchecked, this "deleveraging" process poses a serious threat to the economy.

The IMF has estimated that, without large infusions of government funds, U.S. and European banks over the period 2008-13 would be selling assets and failing to renew existing loans to the tune of $10 trillion, equivalent to a whopping 14.5 percent of their loan portfolios. More than half of this lending contraction would occur among U.S. banks. At this stage, therefore, TARP's success has to be judged not in terms of how many new loans it produces but what problems it has prevented -- fire sales of assets and the cutting off of credit lines.

So far, the TARP capital injection has reduced the size of the problem, but the problem remains large. We are not against providing additional help directly to homeowners, but any substantial diversion of TARP funds away from their central task would be a serious mistake and could worsen this very nasty recession. A restored financial sector must play its part in ending the recession and sustaining an economic recovery. Congress should release the second half of the TARP funds with rules that can actually be enforced and recognize what the program is trying to achieve -- a recapitalization of the banks to limit any further contraction of lending.

Martin Neil Baily and Charles L. Schultze are senior fellows at the Brookings Institution. Baily chaired the Council of Economic Advisers in the Clinton administration. Schultze chaired the Council of Economic Advisers in the Carter administration.


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