By Robert J. Samuelson
Monday, February 9, 2009
If this were a movie, we'd call it "TARP, the Sequel." The Obama administration will soon unveil its plan to bolster the nation's financial system. Given the widespread revulsion to financial "fat cats," the public reception may be underwhelming. But we need to move beyond populist denunciations of "bailing out Wall Street." The purpose of action is more compelling. It is to reverse a massive worldwide credit contraction that's clobbering the real economy of production and jobs.
Global finance has swung from one extreme to the other. Having engaged in excessive risk-taking -- by misjudging the hazards of "collateralized debt obligations" (CDOs) and other feats of financial engineering -- banks and investors have become terrified of almost any risk. The result is paradoxical. As individual financial institutions try to minimize their risks, they increase the risk for the broader economy by denying needed credit or dumping securities (bonds, mortgages).
Here's how the vicious circle works.
With the economy weakening, more loans go into default. Distressed households and businesses can't meet payments. Diane Vazza of Standard & Poor's predicts that the default rate on low-grade corporate bonds will reach a record 13.9 percent in 2009 -- up from only 1 percent just two years ago. Firms that took on heavy debts in "private equity" buyouts seem highly vulnerable.
Growing losses then make investors even more leery of risk. They further curb commitments. The consequences are global. Money flows into developing countries have collapsed. In 2009, they may be down 82 percent from 2007, forecasts the Institute of International Finance. Companies in these countries (Brazil, India and others) have $100 billion of maturing debts in the first half of 2009. The IIF worries that much of this debt won't be refinanced. Scarce credit spreads the global slump.
So, we've gone from too much credit to too little. Contrary to popular wisdom, banks -- institutions that take deposits -- aren't the main problem. In December, total U.S. bank credit stood at $9.95 trillion, up 8 percent from a year earlier, reports the Federal Reserve. Business, consumer and real estate loans all increased. True, lending was down 4.7 percent from the monthly peak in October. But considering there's a recession, when people borrow less and banks toughen lending standards, the drop hasn't been disastrous.
The real collapse has occurred in securities markets. Since the 1980s, many debts (mortgages, credit card debts) have been "securitized" into bonds and sold to investors -- pension funds, mutual funds, banks and others. Here, credit flows have vaporized, reports Thomson Financial. In 2007, securitized auto loans totaled $73 billion; in 2008, they were $36 billion. In 2007, securitized commercial mortgages for office buildings and other projects totaled $246 billion; in 2008, $16 billion. These declines were typical.
Given the previous lax mortgage lending, some retrenchment was inevitable. But what started as a reasonable reaction to the housing bubble has become a broad rejection of securitized lending. Terrified creditors prefer to buy "safe" U.S. Treasury securities. The low rates on Treasuries (0.5 percent on one-year bills) measure this risk aversion.
Somehow, the void left by shrinking securitization must be filled. There are three possibilities: (a) securitization revives spontaneously -- investors again buy bonds backed by mortgages and other loans; (b) commercial banks or other financial institutions replace securitization by expanding their lending; or (c) the government substitutes its lending for private lending. Until now, it's been mostly (c).
The Treasury and Federal Reserve, through various lending programs, are funneling funds to mortgages, student loans, small-business loans and even foreign governments. But a permanent expansion of government's lending role raises practical and philosophical issues. It might politicize lending decisions, involve huge increases in federal debt and pose long-term inflation dangers.
As proposed by President Bush, the $700 billion Troubled Assets Relief Program (TARP) aimed to rehabilitate the private credit system. The Treasury would buy some of banks' bad loans. Thus strengthened, banks could increase lending and offset dwindling securitization. But the Bush gambit failed. The Treasury changed course. It injected capital directly into banks after deciding that it was too difficult to put a price on the banks' bad loans. Unfortunately, banks remain reluctant to lend because they still have lots of bad loans on their books.
Now the Obama administration is crafting proposals to encourage lending. It's a genuinely hard problem. There will be ferocious debate. Will the plan work? Is the cost too high -- or too low? What conditions should be imposed on banks receiving aid? But we should resist turning the debate into a morality play about whether bankers deserve to be rescued. Probably they don't. Even though beating up on them may be politically satisfying, it's beside the point. If the financial sector isn't revived, the economy will stay depressed.