Business Insider

Peter Crabb: Bad loans still on banks' books will prolong recession

What happened to the $700 billion pail? Months ago, when President Bush said “our entire economy is in danger,” his administration asked for and received $700 billion to buy bad mortgage-backed loans off the books of U.S. banks.

At the time, Treasury Secretary Henry Paulson said the frozen financial markets threaten “American families' financial well-being, the viability of businesses both small and large, and the very health of our economy.” Clearly we are all threatened, but so far, he has spent half of the money without buying any loans.

Instead, the Treasury opted for capital infusions – investing directly into banks so as to encourage more lending. These bailouts have created a line of industry managers (e.g., automotive, home builders, steel companies, etc.) interested in government investment: “The banks don’t want to lend to us so we will just call up Uncle Sam.”

The uncertainty in economic policy continues to make for little or no market in the mortgage-backed loans on the books of almost every financial institution in the country. Investors still have little confidence in financial markets and therefore are hoarding cash - piling their money into safe U.S. Treasury bills.

The interest rate yield for short-term Treasurys is basically zero, and 10-year Treasury notes at just above 2 percent are unlikely to cover inflation for the decade before they mature.

Lending remains at a standstill as U.S. banks hold cash, rather than risk it with homeowners and businesses. U.S. banks are holding many times their normal amount of reserves at Federal Reserve banks.

Bankers are unwilling and unable to lend, since they are still holding many low=value mortgage loans. Any new loan risks a violation of the banks’ capital regulations.

Meanwhile, other central banks have not been as aggressive in cutting interest rates. While the Fed has cut bank rates to nearly zero, The Bank of England 2 percent overnight lending rate is above 2-year rates of British government bonds. The European Central Bank’s main lending rate is even higher at 3 percent.

In short, world monetary policy is uneven and ineffective.

The proposed bailout was designed to make a market in the bad loans. If the bailout plan is to bring back confidence, the bad loans have to go.

The current equity infusion plans and uneven monetary responses give no more certainty to capital markets. Until the loans that started all the trouble are sold off at market-clearing prices, the banks will continue to hold onto cash, prolonging the recession.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.