New lending facilities (and why they won’t help)

September 15, 2008

(Complete coverage of yesterday’s events in the posts below)

CalculatedRisk is reporting that the Fed has expanded the types of collateral it is willing to except in exchange for loans.  A year ago it only accepted the highest-quality (least risky) collateral in exchange for a loan. Treasury bonds, for instance.  Now it will be accepting equities(!).

Moreover, 10 major Wall St. banks have announced a new $70 billion loan program to help banks get through the latest chapter of the Credit Crisis.

A group of global banks and securities firms announced late Sunday a $70 billion loan program that financial companies can tap to help ease a credit shortage that threatens global financial markets.

The ten banks, which include JPMorgan Chase & Co. and Goldman Sachs Group Inc., said they were committing $7 billion each for the pool. The pool would act as a signal to the marketplace that banks, brokerages, and other financial companies can lean on the fund to take care of borrowing needs.

First of all, you thought we were going to get through the weekend without another Fed bailout?  Well, you thought wrong.  Over the past year the Fed has offered up its balance sheet to banks that are in need of cash to fund their operations.  Theoretically, it’s just making loans to the banks.  Loans that have to be paid back.  But as the Fed loosens its own lending standards, allowing riskier institutions to put up riskier collateral, its putting taxpayers at greater risk of loss.

It’s not an overt bailout, as with Bear/Fannie/Freddie, but a bailout nonetheless: putting taxpayers at risk to help “stabilize” markets.  Besides the Fed taking additional risk onto its balance sheet, you also have the Federal Home Loan Banks that have lent hundreds of billions to some of the weakest banks (Countrywide and WaMu, for instance).  Such banks lost most of their private sources of capital (other than deposits) and the FHLB system saved them.  Is it any wonder that the Fannie/Freddie credit line announced last week also includes the FHLBs?  They may need a bailout before all is said and done….

Will all of these lending facilities help?  Probably not.  As Economist Nourial Roubini (aka Dr. Doom) has long and correctly argued, the fundamental problem confronting the American financial sector isn’t illiquidity.  It’s insolvency.

An illiquid bank may simply have a short-term funding problem.  Say for instance your local community bank experiences more withdrawals than anticipated on a particular day, so many that by the end of the day it doesn’t have enough funds on hand to meet withdrawal requests.  For the moment, the bank is illiquid.  It needs a loan to meet withdrawal demand.  But the bank will be able to pay back ITS loan once the bank’s borrowers pay back the principal and interest they owe the bank.

An insolvent bank is in deeper trouble.  Its problem is that its borrowers aren’t paying back their loans.  Perhaps it lent its depositors’ money to a real estate developer who’s gone bust.  A temporary loan from another bank in order to meet unexpectedly high withdrawals won’t do any good since this bank has no funds coming in to pay back its loan….

The sickest American financial companies aren’t merely illiquid.  After years of pumping depositors’ money into loans or securities for worthless(?) real estate projects, they are insolvent.

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