Why Aren't Banks Lending

This figure from the Wall Street Journal shows the changes in bank lending for 10 of the 13 largest beneficiaries of the government's Troubled Asset Relief Program (TARP). The overall drop in loan volume has many politicians and taxpayers wondering what happened to the more-than $200 billion dollars spent in the first tranche of the bailout package.

There are a few basic reasons for the general tightening of credit. First, banks are still concerned about the deteriorating economic climate that could imperil even more of their assets. If these institutions face further write-downs (reducing the book value of their positions on their balance sheets) they will need TARP money simply to offset these losses. This process of "augmenting capital" is a way for banks to protect themselves against an uncertain future.

Second, banks used some of this cash to buy US treasuries and, in some cases, rival institutions. In effect, critics argue, the government provided cash for balance sheet "window dressing" (adding government bonds to the portfolio) and a slew of mergers and acquisitions (for which there was no financing on the open market). Bankers claim that these investments reflect their efforts to minimize risk exposure. As layoffs continue, lenders are worried about delinquent debt. Still, such behavior has fueled public skepticism about the Wall Street's motives.

There is, however, another reason that banks have pulled back on lending. Recent financial innovations have changed the way in which banks conduct business. Rather than simply accepting deposits and making loans, banks have increasingly embraced securitization. When banks securitize loans, they bundle up assets in their portfolio and sell them to investors, removing them from their own balance sheet. Until the collapse of mortgage backed securities, this strategy was an innovative was to minimize risk and still generate profits.

Here's where the banks got into trouble. The tranching of collateralized debt obligations (CDOs) allows investors to take different levels of exposure to default. More senior tranches are less risky, but have the lowest returns in the portfolio. The most junior tranche (known as the equity tranche) assumes the most risk, however, this class of CDOs can generate 15-20% returns. When banks securitized loans, they often sold off more senior tranches, but held the equity tranch so as to reap the benefits. During the housing boom, this strategy proved extremely lucrative.

Now these synthetic CDOs are squeezing banks at both ends. As housing prices fall and defaults increase, the tranches which banks are holding are the first to lose value. In addition, there are very few investors who want to buy bundled securities from banks, thus undercutting an important revenue stream for banks. In modern finance, banks don't lend to make interest, they lend to securitize. As a result, bailout packages that increase bank's capital reserves will not necessarily increase their loan volume.

It is misleading to say that banks have completely stopped lending. On the one hand, there are data that show otherwise. But more accurately, bank lending is a market-driven enterprise, where rates are determined by supply and demand. As banks become more fearful of defaulting loans, the rate at which they are willing to lend money rises (often prohibitively). Under these circumstances, even credit-worthy companies are facing a higher cost of borrowing.

Forcing the banks to lend will be a difficult, if not fruitless, task for lawmakers. As Congress calls for prudence and responsibility in the financial world, these institutions may argue that fewer loans are precicely in order. One thing is for certain, there has been no easy way to loosen the credit market.