Banks Not Lending?

A letter:

I have been struggling with figuring out where the banks are getting money to pay back the TARP loans with all the bad loans they have on books and the fact that they are not lending money. I do not see where they are making money suddenly to pay off TARP and pay bonuses!

Thank goodness you got to KPC in time, where ALL can be explained!

The banks are getting money from two sources:

1. The Federal Reserve System, through the its Open Market Desk in NY, and through other outlets, is POURING money into the system, in the form of reserves. Banks, as a result, have an extraordinary amount of cash.

How does the Fed do that? They buy long-term Treasury bonds. Banks can hold reserves in cash or bonds. Many were holding bonds, because there is an inverse relation between interest rates and the value of bonds. If interest rates fall, bond owners take a capital gain. Rates have fallen a lot over the past 14 months. But now rates are near zero. So banks are happy to sell bonds.

When the Fed buys t-bonds, it takes money out of its account at the Treasury (and that account is NOT part of the money supply) and transfers it to the accounts of banks and other entities. Say Fed buys a $1 million dollar bond from Bank of America. BoA has no more wealth than before, but it suddenly has an extra $1 million in cash it needs to invest. The Fed has been increasing the money supply in just this way for the past year or more, at a rate of 10% per month. (I didn't stutter, 10% per month, biggest sustained increase ever, in absolute terms).

2. The assets (collateralized debt obligations and other mortgage-backed securities) have become a little less illiquid. A year ago, nobody would buy CDOs at any price. Now, that part of the credit market has unfrozen a little bit. Banks may still be bankrupt, on their balance sheets, but they can get their hands on some cash, lots of it, by selling off CDOs and other assets.

So, why aren't we seeing the RETAIL credit market unfreeze, since the WHOLESALE credit market, described above, has plenty of cash?

Again, two reasons. First, banks are still trying to avoid risk. And it is not clear that recession is over, in the real world. So banks are borrowing money from the government, at 0%, and then buying NEW federal debt, which pays 3%. That's a guaranteed 3% real return, with no risk. So the Fed buys up debt to increase the money supply, to get the banks to lend. But the banks just buy more government debt, lending to the government instead of lending to small businesses or even large businesses.

And the government is having to borrow more and more to finance the deficit being used to bail out the banks. But the banks are just using the bail-out money to buy more of the debt being used to finance the bail-out! From the taxpayer's perspective, you'd be better off playing the "3-card monte" games in Times Square.

Second, the rush of cash is causing an "asset inflation" which I had always thought was just a wild hypothesis, something that could never happen in the real world. But it IS happening. We aren't getting broad inflation (though the Producer Price Index has been up at a nearly 6% annual rate the last two months!). But the stock market is looking pretty good. But it may simply be because the Austrian Econ prediction of an asset inflation is correct.