Instead of lending, banks focus on covering losses

President Obama has been demanding that banks start lending again, but the unstated secret is that banks are not lending much because they are busy paying back their government aid and covering losses of $1 trillion or more on defaulting loans.

Banks and the administration all but abandoned efforts to clean up their immense toxic-loan problems through the bank bailout program earlier this year, and instead have been hastening to settle accounts. All of the top banks have repaid their bailout funds to free themselves from public scrutiny and government interference, and the Treasury has been trumpeting the return of $164 billion in bailout funds by year’s end.

But that means banks now have to rely on their improving profits and private fundraising to try to offset a steady stream of big write-offs for souring loans on everything from credit cards to prime mortgages and commercial real estate. Estimates of total bank losses on defaulting loans over the next few years range up to $4 trillion.

Analysts warn that the slow and painful process of writing off this enormous amount of bad debt one quarter at a time could take years or even decades to complete, as it did in Japan - and the economy will suffer in the meantime as businesses and consumers are starved of credit that would be more forthcoming if the banks had healthy balance sheets. Small businesses are particularly vulnerable because they rely disproportionately on banks for credit.

“We need to clean up the overhang of toxic assets, which sit in zombielike banks,” said Rhajeev Dhawan, director of the Economic Forecasting Center at Georgia State University. “Delaying it is what Japan did. It didn’t work. While banks are writing off the bad debt, they don’t make any loans.”

Mr. Dhawan said the credit crunch is particularly acute for small businesses, which can’t even get off the ground without bank credit. New business formations have stalled because community banks are weighed down with souring commercial real estate loans. Burgeoning loan losses have brought down 134 banks closed by the Federal Deposit Insurance Corp. this year.

The veneer of profitability at banks and the large bonuses some have been giving their top performers this year have diverted attention from the large, festering loan problems that continue to eat away at banks, analysts say.

“The banking crisis has moved into a second stage” as banks slowly write off bad loans on their books, said James Ferguson, chief international strategist at Pali Capital. Mr. Ferguson estimates total U.S. bank losses on loans of all kinds at $1.6 trillion, while other analysts say the losses could run as high as $3.8 trillion amid rising unemployment, defaults and foreclosures.

But banks so far have reported only a little more than $607 billion of those losses, suggesting that they have publicly acknowledged only the tip of the iceberg, Mr. Ferguson said.

“That would imply that the loss-recognition process, which took almost two decades to complete in Japan, is not yet much more than one-third of the way through,” he said.

The glacial pace at which Japan’s banks wrote off bad debts led to what economists have dubbed the “lost decade” in Japan - fully 10 years, during which banks stopped making new loans and the economy stagnated, never posting sustained growth of more than 1 percent. While U.S. regulators are forcing banks to recognize their losses more quickly, analysts say it still could take years for them to fully come clean at the current pace.

Some experts say banks are not hampered so much by a backlog of bad debt and lack of funds as they are by squeamishness about lending to consumers and businesses again after suffering such huge losses.

“It’s pure risk aversion,” said Jim Spitzer, a lawyer at Holland & Knight, who noted that banks could easily be lending more with their record excess reserves of nearly $1 trillion and access to almost cost-free loans from the Federal Reserve.

“They don’t want to take the risk of making loans” when the economy is so weak that new loans could result in further defaults and losses, he said.

Banks also have an attractive alternative that enables them to make money without taking any risks, he noted. They can invest their reserves in U.S. Treasury bonds and make easy profits that way, he said.

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