Consultant Ninja: A Simple Question about the Credit Markets: Management Consulting Blog

Tuesday, March 31, 2009

A Simple Question about the Credit Markets

Here's my understanding of the current TARP/TARPII/PPIP/etc plans:

The major "sick" banks won't lend to businesses, because their balance sheets are tied up with bad assets that they can't sell. The government will buy those assets, freeing up the major banks to loan again to businesses.

I realize that is a gross simplification, but if the gist is right, it leads me to a simple observation:

Why doesn't the government just give long-term loans to the healthy banks (building up their balance sheets) so that they can loan to businesses? Why are the major "sick" banks the only vehicle to provide credit to businesses?

9 comments:

Anthony Jen said...: The question would be: which bank is not sick? Major banks either got intoxicated themselves or merged with cancer banks. BoA even got 2 of those.; March 31, 2009 at 9:52 PM
Consultant Ninja said...: Most credit unions, and any smaller banks that didn't load up on a) subprime loans, or b) MBS/CDO securities.; March 31, 2009 at 10:03 PM
Anthony Jen said...: My guess would be the problem of mismatching supply/demand. Major banks, before the crash, played the role of purchasing, packaging and reselling mortgages in form of securities; they could do that because most of them have brokerage arm. Credit Union have a much simpler business model. Now, no major bank can find investor(which includes themselves) with enough appetite to consume those papers. That is why, I guess, Geithner has elected to stimulate the demand for toxic asset.

I think what you say makes sense, but implementation of your idea requires quite an re-allocation of industry resources.; April 1, 2009 at 1:14 AM
Consultant Insider said...: Isn't also true that providing funds to the sick banks also insures they don't go under? So you improve the flow of credit, and avoid another major collapse in one go.; April 1, 2009 at 1:44 AM
Consultant Ninja said...: AJ: I totally agree that it massively shift market share from the sick banks to the healthy banks. But wouldn't that be a better market result than letting the sick banks keep their share?

CI: What's the problem if a few banks go under, as long as credit flow to the real economy remains? Banks fail all the time, right?; April 1, 2009 at 8:23 AM
Joseph Greiner said...: I think you all have some really good points, however, the problems are much more complex. For simplicity I have listed a few thoughts.

1. Failure of a large financial institution would collapse the global economy and force a worldwide depression
- One of the primary drivers of the Great Depression was the Feds inability to act before an actual run on the banks occurred. Should this happen we would suffer major systemic failure, potential hyper-inflation, and illiquid capital markets. For all intensive purposes a major run on the banks would render the FDIC useless.

2. The establishment of large financial institutions consolidates the problem, reduces systemic risk, and keeps transaction costs low
- Assuming that the break-up of large financial institutions is going to solve the industries thirst for risk is not necessarily a plausible assumption. It is probably much easier to diagnose and treat 4 or 5 patients than a group of 100, 200, or +1000. If you look at the 1987 Savings and Loan crisis you will have a better indicator of the consequences associated with the localized banking approach.

3. Smaller banks do not have any subprime mortgages, CDO's, or CMO's in their portfolio.
- While smaller banks are often more reluctant to underwrite riskier loans, they are still exposed to the broader capital marketplace. Despite not having a derivatives / trading desk, they still buy and sell portions of their portfolio as needed. Also, in order to hedge localized risk, they also include MBSs and CDOs in their portfolio. While that is not their primary business they are all inter-connected

My solution for the whole TARP / "toxic" asset plan is as follows:
The government will spin off a separate entity from all of the banks in which they have a stake; whereas, the government receives an ownership stake along with the bank and they actively work together to value illiquid loans and re-establish a market pricing mechanism. I think this approach is more efficient because it reduces transaction related costs and provides a gain sharing program which is mutually beneficial for all parties. Either way, I am not nearly as pessimistic as everyone else.

I really enjoy your blog....keep on keepin' on.; April 1, 2009 at 9:44 AM
The ANALyst said...: A lot of companies, including a lot of consulting companies, have professional indeminity insurance with the likes of AIG. So if AIG were allowed to go under, it would potentially cause a few problems. Esp. for some of the big system integrators who frequently tend to get it wrong.; April 5, 2009 at 1:06 AM
Anonymous said...: another question: even if banks were to somehow become willing to lend again, what makes you think their clients will want to borrow?

What business seeks to borrow to invest when it faces 1) a declining sales and revenue outlook and 2) is saddled with debt against collateral that is declining in value, such as commercial real estate?

What about consumers? After what they have experienced, what consumer will rush to take on more debt when she is already saddled with mortgage debt against a house that is declining in value, and faces the prospect of losing her job, if she hasn't lost it already?

Assuming that the problem lies with "banks unwilling to lend" is wrong; April 15, 2009 at 11:22 AM
Consultant Ninja said...: Anonymous: refinancing of existing debt that is coming due.; April 15, 2009 at 1:13 PM