Bankruptcy

The Moral Hazard of Treasury's "Equity" Injection

By Adam Levitin

Treasury Secretary Paulson is jawboning banks to use the Treasury's capital injection to lend, rather than to just sit on the funds. This is very telling about the way Treasury sees the financial crisis and should concern us because it sets up a moral hazard and papers over the looming problem of the US economy: consumer overleverage.

Treasury is rightly concerned about the stability of financial institutions not for their own sake, but because of the crucial intermediating role they play in the economy. Treasury is investing lending money to the banks not just so that they will be stable, but in order to get them back into the business of intermediating between capital markets and borrowers in order to get the rest of the economy humming again.

The problem is that there might not be enough creditworthy borrowers and Treasury's investments loans and guarantees create a moral hazard. The banks are gambling with other people's taxpayer money. (And increasing FDIC insurance makes this problem worse). Banks have a chance to make great spreads--5% cost of funds, with lots of credit starved borrowers around who will pay major premiums (or have to workout defaulted loans). But a lot of the potential borrowers just don't look like good risks any more. Cheap funds, shifting of risk, and wild lending is what got us into this mess. And the equity injection combined with Paulson's comments looks like it is setting us up for a repeat.

Consider who banks might lend to. Consumers? Many are underwater on mortgages and auto loans and credit cards are teeing up for major losses. Business lending, perhaps, but how much distressed loan exposure does a bank want? And banks might lend to other financial institutions, such as hedge funds that are suffering from mass redemptions, but that's also high risk.

Obviously Treasury doesn't want to see a repeat of the current debacle. But the fact that it is engaged in a program that creates a moral hazard and is encouraging banks to lend, even if they think it is more prudent to sit on capital, points to the essential quandary of Treasury.

The US economy is fueled by consumer spending. In order for the economy to grow, consumer spending has to grow, and consumer spending is fueled by debt. Consumers largely spend not out of current assets or current income, but out of future income. Consumers are able to do this because of their assumptions about their current assets--especially their retirement savings. Unfortunately, consumer behavior for the past seven years has been shaped by the unrealistic expectations formed in a bubble. Consumers have saved less because they thought they had a bigger investment cushion. This sets us up for a retrenchment in consumer spending, which is exactly what Treasury does not want to see. In order to keep consumer behavior the same, Treasury needs to reinflate that bubble. But doing so just sets us up for another crash.

General consumer financial health would be helped by a shift to greater savings. But any shift will cause a short term contraction in consumer spending, which will mean economic pain for a while. This is a bitter pill to swallow. But it might not be as bad as the alternative, namely the economic effects of consumers becoming so overleveraged that we see massive defaults on all sorts of debts.

Full post as published by Credit Slips on October 14, 2008 (boomark / email).