April 19, 2009
Repaying the Government's Loans to the Banks Comment
Repayment of Tarp Bank Loans
Repayment of Tarp Bank Loans-Becker Six months ago essentially all large American banks and many smaller ones received loans from the federal government to help shore up their capital base as they tried to weather the financial storm. Some banks would likely have failed during the severe strains in the capital market last September and October were it not for these loans. This past week, however, the two strongest large banks, Goldman Sachs and JPMorgan Chase, indicated that they wanted to, and were able to, repay their loans. Should they be allowed to do so? It appears that not all banks wanted to take government loans in October, but some large banks were apparently "forced" to as part of the TARP loan program devised by then Secretary of the Treasury Henry Paulson. According to some accounts, the government exercised this pressure in order to avoid disclosing which banks were the weakest and needed these loans to survive. This explanation of the government's behavior is strange since generally participants in financial markets do not have an excess of information about the financial viability of different banks, but rather they do not have enough information. It is wrongheaded for the government to try to mislead markets about which banks are weak. Indeed, the purpose of disclosure requirements mandated for banks and other companies is to raise the degree of public information available about different companies in order to assist participants to make wiser decisions. In any case, most firms and individuals active in financial markets already had a fair idea of which banks were stronger and which ones were weaker. Many of the banks worse fears about the strings attached to these loans have been realized. The resulting government intervention in bank managerial decisions include the well-publicized restrictions on bonuses and other pay to executives, restrictions on banks' ability to hire foreigners, and frequent demands to appear before Congressional committees to justify what they are doing. Less onerous interventions include Congressional and the media's opposition to banks holding expensive golf and other outings, bank use of private planes, and meetings at luxurious resorts. Goldman, JPMorgan, and other banks want to repay their government loans primarily to eliminate these and potentially other government restrictions on managerial decisions. I see no compelling reason why they should be prevented from repaying their loans. One argument made against allowing them to repay is the same one used to justify requiring the relatively strong banks to take the loans in the first place; namely, that the weaker banks would be exposed if the stronger banks repaid at this time. However, they are already exposed since the major participants in financial markets already know that banks such as Goldman and JPMorgan are much stronger than say Citi and Bank of America. A more sophisticated version of this argument is that if the strong banks were allowed to repay now, the weak banks would also try to repay, and thereby become still weaken, since they do not want to appear weaker than their competitors. However, weak banks are unlikely to try to repay if that would so further weaken them that they would soon require even larger government bailouts before long. Moreover, repayment by strong banks would be a good motivator if it gave weaker banks stronger incentive to get into a financial position whereby they too could repay without damaging their viability. Another argument advanced against allowing any repayment at this time is that this would weaken the capital position of repaying banks (even those that claim to have enough capital to repay). Yet especially the stronger banks would not want to repay the Tarp loans if that means that before long they have to ask the government for additional loans. Goldman has raised an additional $5 billion in equity to help finance their repayment, and the company has reduced its assets to 14 times its capital compared to 26 times at the end of 2007. JPMorgan claims to be able to repay their loan without having to raise any more capital. In any case, the Treasury is soon releasing results of the stress tests they have given to all major banks. We will then have better information to determine if the banks that want to repay now can comfortably pass these tests. I am confident that these banks will rank quite high, which would help explain why they are eager to repay. If Goldman and JPMorgan were simply allowed to repay their TARP loans, they would still have the sizable benefits of the Temporary Lending Government authority (TLGP) that provides FDIC guarantees on bonds issued by covered banks. These guarantees stem from Goldman 's conversion into a bank holding company last fall-JPMorgan was already such a company. Goldman has borrowed about $28 billion under TLGP. This would be the right time to start reducing these guarantees for Goldman and JPMorgan as a condition for these banks being allowed to reduce government controls over their decisions.
Repaying the Government's Loans to the Banks--Posner's Comment
Last fall the federal government lent hundreds of billions of dollars to major banks and other financial intermediaries pursuant to a program called the Troubled Asset Relief Program (TARP). Some of the recipients, notably Goldman Sachs and JPMorgan Chase, want to repay the money. Essentially that means buying back the preferred stock that the government received in exchange for the loans; they thus were loans without a maturity date.
I do not know whether, as a matter of law, the government's consent to repayment is required, although it would not be surprising if it were, since, as I said, the government received preferred stock for the loans rather than just a promise to repay. But maybe there's something in the loan contracts that entitles the banks to repay when they want to; I do not know, but I'll assume that the government's consent is required and consider whether that consent should be given.
The answer depends in part on an understanding of why the loans were made. Last September it appeared that most of the nation's major banks and related financial intermediaries were either insolvent or in danger of becoming so; TARP was designed to save them. Had the banks been allowed to go broke, the depression in which we now find ourselves would be even more severe than it is; think of the chaos that ensued when Lehman Brothers, one of the lesser financial intermediaries, was allowed to fail that month. No private investor was willing to step in and save the tottering banks, so the federal government stepped in instead.
TARP proved highly unpopular with Congress and the general public. The main reason was that the banks were seen to be "hoarding" the money they had received from the government, rather than lending it. TARP had been sold to a public suspicious of "Wall Street" (an echo of age-old hostility to finance as "sterile," rather than "productive" like making a physical product) in part as a way of stimulating economic activity by enabling banks to increase their loans. The idea was that the hundreds of billions of dollars fed the banks by the government would go out as loans to the bank's customers. And loans do stimulate economic activity. Many businesses rely on bank loans to bridge the gap between incurring costs of production or distribution and later receiving revenues from the sale of goods and services; and both businesses and consumers use borrowing to bring production and consumption, respectively, forward--borrowing to spend means consuming more today and less in the future (the eventual repayment of the loan will reduce the amount of money that the borrower has for spending on investment or consumption). A depression is a severe contraction of output, and borrowing is a way of increasing output by increasing the amount of money that people and firms have for immediate spending.
The hoped-for expansion of lending did not take place. Contrary to myth, at no point did banks cease to make loans, although they came close to doing so last September and October. But they did reduce their lending, both by raising interest rates and by increasing credit standards and, in some cases, by refusing to lend to other than their best, established customers. The money that the banks received from the government was mainly either hoarded quite literally, or used to buy bonds or other assets (including in some cases other banks). By literal hoarding I mean keeping the money received from the government in cash or a cash equivalent, such as a bank account in a federal reserve bank. Banks are required to keep a modest percentage of their demand deposits in cash; these are their "required reserves." Any excess cash they have is called "excess reserves," and since cash does not earn interest, banks usually try to minimize their excess reserves. In 2007 their excess reserves amounted to only about $2 billion; today, they are almost $800 billion. When banks are worried,"excess" reserves are not really excess.
Why did the bankers not lend the money they received from the government? There are five reasons: (1) because banks were undercapitalized, as a result of being overinvested in assets that had lost much of their value, such as mortgage loans and interests in mortgage-backed securities; (2) because they anticipated big losses from their outstanding credit card and commercial real estate loans, and perhaps from other loans as well (this is related to the next point); (3) because lending in a depression is highly risky--the default risk is high, and if the lender tries to compensate for the risk by charging a very interest rate this will increase the risk of default, because interest is a fixed cost of the borrower, that is, invariant to his revenues; (4) because as businesses reduced their output their need for borrowing fell and the risk of default (as I just mentioned) rose, making them reluctant to borrow; and (5) because consumer borrowing fell as a result of consumers' being overindebted as a consequence of the fall in house and stock values, the principal source of their savings. Of course failing businesses and unemployed or otherwise necessitous consumers might want desperately to borrow, risky as their borrowing would be. But they are unattractive customers for banks, especially when the banks, because they too are overindebted, are trying to reduce the riskiness of their loan portfolios.
These reasons for the banks' reluctance to use federal money to make loans are perfectly good reasons, and do not invalidate the TARP because without the additional capital that the program contributed the banks would have been even more chary about lending. But the reasons that despite TARP bank lending is continuing to decline were never adequately explained to the Congress or to the public, and as a result the failure of the banks to lend more was and is seen as sinister. And when it turned out that banks were continuing to pay high bonuses and other generous-seeming compensation to their employees, Congress and the public accused the banks of being a conduit between the federal taxpayer and the "stupid, greedy, reckless" bankers who had brought down the banking industry and, with it, the nonfinancial economy.
Again, no one explained that (1) bankers are smart, and the collapse of the industry last fall was due to a combination of dumb Federal Reserve interest-rate policy in the early 2000s and the excessive deregulation of financial intermediation, beginning in the 1970s; (2) bonuses are a more efficient form of compensation than salary, because they are more closely aligned with performance; and (3) the problem of overcompensation is a problem of senior management, because of its de facto control, in a large, publicly trade corporation, of the board of directors; most recipients of bonuses in financial intermediaries are not part of senior management. Somehow Congress and much of the public got into its head that the banks had hired dopes and deliberately overpaid them, which would make no sense from the standpoint of senior management.
The uproar over the banking industry has led to legal restrictions on compensation, proposals for other highly intrusive forms of regulation, even threats to "nationalize" major banks (that is, confiscate them), congressional witch hunts, interference with banks' use of private aircraft and with promotional activity at resorts, adverse publicity, and other inroads into the autonomy and efficiency of financial intermediation. So naturally the banks are scrambling to repay the TARP money as fast as they can, in the hope of getting the government, the public, the politicians, and the media out of their hair.
I can't see a good reason not to allow them to repay the loans. Repayment will go some distance toward reducing the astronomically mounting federal deficit and will allay, to some extent at any rate, the public and legislative hostility to banks and bankers. That hostility is counterproductive. By increasing the uncertainty of the banks' business environment, the attacks on the banks increase their incentive to hoard cash or to make safe investments rather than to make loans. (So who is being stupid and reckless?) There is I suppose a danger that some banks would repay prematurely, that is, before the risk of insolvency has been dispelled, but that is unlikely. As Becker points out, a bank would be reluctant to repay its government loans if it anticipated a significant probability of having to return soon to the government, hat in hand, for a further loan because it has gotten into more financial difficulties.