Giving Credit Where Credit Is Due

This phenomenon created many new players in the credit market, many of which were not regulated by the government. Plus, Wall Street investment banking firms and securities rating agencies like Moody’s and Standard & Poor’s made extraordinary amounts of money in the underwriting and rating fees of all these securitization transactions—much more than in traditional deposit and lending activities that are the bread and butter of the banking industry.

“And these high-risk subprime mortgage products relied on models and assumptions based on theories untested by any historical experience,” Doyle says.

At the same time, the government was keeping interest rates low to encourage commercial real estate development and stimulate consumers to buy more stuff like cars and televisions, which also resulted in a lot of credit card debt. It was a recipe for disaster, and we all now know firsthand what that disaster looks, feels, tastes, and smells like.

What does this have to do with bank credit, you ask? Well, most of those nonbank originators of mortgages, auto loans, and credit cards have now disappeared. “Eighteen months ago, there were a lot of other third-party financial institutions extending credit, so the overall amount of credit availability was much larger,” Doyle says. As people lose their jobs and are unable to repay their loans—and demand for many business products has slowed—banks have imposed stricter terms on customers’ ability to repay, he says.

“Banks just aren’t going to do any marginal transactions right now,” Doyle says. “Banks can’t fill the credit void by themselves to get back to the way it was. It’s time to rightsize and decrease the overall size of credit, and we still have not found equilibrium.”

So three factors have contributed to this so-called credit crunch:

• Nonbank originators have disappeared;
• Weak banks aren’t strong enough to lend;
• Healthy banks aren’t comfortable with lending in this environment.

Here Comes TARP

So that’s where the government stepped in with TARP and made about $700 billion available to financial institutions. In other words, the government is buying up troubled assets to avoid a complete collapse of the economy should Citigroup, Bank of America, AIG, and General Motors (to name a few) all go bankrupt or become seriously distressed.

Included in the overall TARP fund is the Capital Purchase Program, where $250 billion is being spent by the federal government to purchase bank preferred-equity shares. It’s not a bailout, it’s a preferred stock investment with annual dividends of 5 percent for the first five years and 9 percent thereafter. Banks getting TARP funds had to agree to certain conditions and compensation restrictions. The first $125 billion was spent on the largest banks that were considered too critical to fail.