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Peter Crabb: Why Geithner thinks even more money for banks is necessary

The potential return on risky assets is apparently too high. U.S. Treasury Secretary nominee Timothy Geithner appeared Wednesday before members of the Senate Finance Committee arguing that the economy will not improve until more investors are willing to take risk.

Mr. Geithner said he would consider changes to how the $700 billion Troubled Asset Relief Program was implemented, now that Congress agreed to release the second $350 billion tranche of funds under the massive bank-bailout program. Mr. Geithner went on to say, however, that more “direct support” for the capital markets is needed.

He would like to see risk premiums much lower for credit markets to improve and a sustainable recovery to take hold.

Risk premiums refer to the interest rate investors in non-governmental debt receive relative to government issues. When risk premiums are high banks are less likely to lend. Better to hold on to the cash than risk it with businesses.

The corporate debt market is large, with approximately $4.0 trillion in outstanding securities, but still small compared to U.S. Treasury debt, government-agency bonds, and municipal bonds. The corporate market remains, however, perhaps a more important indicator of economic activity.

Corporations rarely issue stock but frequently borrow for new capital projects and to support operating cash flow. The stock market may be taking its lumps, but policymakers see the debt market freeze as more problematic.

Issuing stock gets a company rolling, but debt financing keeps it on the road. Geithner and other policymakers see too many bumps in this road.

The Securities Industry and Financial Markets Association (SIFMA) reports the corporate bond market has seen the average option-adjusted spread rise from roughly 80 basis points (0.80 percent) in early 2007 to over 500 basis points (5 percent) today. That is, investors in corporate bonds used to be happy with double the rate, but today require four or five times the rate of interest paid by U.S. Treasury notes or bonds.

If release of the second $350 billion tranche of funds from TARP is successful, banks will be in a better capital position and can support the debt needs of corporations. Firms can thereby finance capital projects and operations without turning to the corporate bond market, and risk premiums will decline.

Like all other corporations, banks have been unable to borrow in the corporate debt market and want, or need, more capital. It is not really in their interest to remove all the bad loans (troubled assets) from their books, as this will just reduce their cash flow and potential profits. Rather, they are looking for more capital to keep them in business.

This is how a federal program designed to remove bad loans turned into a massive government investment in previously private banking corporations. When the United Kingdom decided in the midst of this crisis last October to bailout their banks, U.S. banks asked for, and got, a similar deal. No fire sale of assets, just more capital. The credit freeze remains in both countries.

The U.S. banks are playing political games by convincing the U.S. Treasury that direct equity investments in their companies (bailouts) are better for everyone. They are playing the British officials against the U.S. officials in a beggar-thy-neighbor policy game.

The risk premium is likely to stay too high for policymakers as long as this game continues.

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.