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Why Aren't Banks Lending?

Banks would rather return "TARP" money to the government rather than lend it out. Why is this? Even though they have been unworthy "agents" in the past, they may be observing, and retransmitting the right market signals. And if we have even a modicum of respect for bankers, we ought to take them af face value in this instance.

Banks lend money in order to make money. So, too, should the people that borrow from them. Money has a cost, expressed as an interest rate, which is a way of rationing it. Let's say that rate is 6%.

In normal times, people that borrow at 6% honestly believe that they can earn at least 6% on their money. In fact, they usually expect to earn more, thereby providing a margin of safety. That's because a company, let's say, has a list of projects that can earn perhaps 50%, 30%, 20%, 15%, 12%, 9%,8%, 7%, 6%, etc. The company will borrow (or use internally generated funds) to fund the first five projects, with double digit returns. It can profitably borrow to fund the next three projects with high single digit returns. The next (6%) project is breakeven, and anything borrowed above that is a loss.

The problem at the corporate level is that the banks funded too many 4% and 5% projects with 6% loans, which meant that they stood to lose money on such loans. Sometimes the corporations repaid out of more profitable projects, and sometimes they didn't. But someone lost money on those negative "carries."

A home owner should feel the same way. Let's say that someone is paying $750 a month for rent, or $9,000 a year. A third of that needs to be spent on maintenance, so two-thirds, or $6,000 can be used to service a mortgage. At a 6% rate, the homeowner would rationally take out of a mortgage of no more than $100,000. If the required mortgage were greater than this s/he would rent, otherwise buy.

Problem was, banks used the lure of home ownership tricked many such homeowners into paying $1,000 a month for quarters they could rent for $750 a month. They may have done this using "split" teaser rates; $500 a month for the first two years, $1000 a month thereafter. A consumer that can afford $750 a month of rent might not be able to afford $1,000 a month mortgage. So banks and consumers are both worse off.

The problem is that banks not only can't make loans for a $1,000 a month mortgages, they've bled dry the pool of customers that could pay $750 a month. House prices are too high relative to rents, meaning they are unprofitable investments. When major corporations like GM and Chrysler are similarly on the ropes, banks have no one to lend to.