- The Washington Times - Monday, July 20, 2009

Washington’s political leaders and the nation’s big banks seem to have come to an uneasy truce after months of open warfare.

Top banks are returning the money Treasury gave them and mostly boycotting the department’s lending revival programs in return for less meddling from Congress and the administration.

But analysts say the consequence of allowing banks to follow their natural urge to hunker down during a recession is that credit for consumers and businesses continues to shrink. Meanwhile, banks sweep their bad loan problems under the rug and nurture profits by, among other things, investing heavily in Treasury bonds.

The shift in Washington’s stance was illustrated dramatically by Treasury’s refusal last week to rescue CIT, a top lender to small businesses with shaky credit. After prodding banks for months to step up lending to small businesses - even setting up complicated government programs to promote loans to them - the administration abandoned the biggest lender in that market. That decision is likely to accelerate the cutoff of credit to many retailers, importers, franchises and other small businesses.

Peter Morici, a business professor at the University of Maryland, called it “doughnut economics.”

“The stock market is rallying. The economy will recover by year end, and strong profits among big players like Goldman Sachs, IBM and Google will spread to other big corporations. However, many small businesses and working Americans won’t be cheering,” he said.

While troubled big banks like Citigroup and Bank of America were showered with federal largesse to keep them afloat, “regional banks that rely on Wall Street for credit simply can’t get enough money to make loans or they end up like CIT Financial and others - broke and bankrupt,” he said. Wall Street has an “increasing aversion to the ordinary business of making sound loans, and obsession with abusive derivatives trading and the big bonuses that creates.”

Dozens of small banks have been quietly closed or merged by the Federal Deposit Insurance Corp., while Treasury has gone to great lengths to rescue banks deemed “too big to fail.”

Meanwhile, “small and medium-sized manufacturers, builders and retailers that rely on those disenfranchised regional banks can’t borrow enough money to sustain operations,” Mr. Morici said.

That lending for most consumers and businesses has stalled or declined since the beginning of the year is unmistakable. Figures published by the Federal Reserve show that commercial bank lending to consumers, homebuyers, real estate developers and businesses is down by nearly $200 billion since December, despite the establishment of Fed and Treasury programs to jump-start lending.

Meanwhile, banks have increased their purchases of Treasury bonds and mortgage bonds issued by Fannie Mae and Freddie Mac by nearly $100 billion, helping the Treasury finance its own burgeoning debts.

As they often do during recessions, banks purchase Treasury bonds rather than make loans because it is a safe way to make money while trying to work down and write off souring loans to consumers and businesses. Since banks pay nearly zero interest on the funds they borrow from the Fed, they can earn considerable arbitrage profits by investing in higher-yielding but safe government bonds while avoiding riskier loans to consumers and businesses.

For consumers, the retrenchment in credit has been the most dramatic on record. Credit card debt and loans of all kinds except mortgages have fallen at a 6 percent rate since fall, when consumer borrowing peaked, according to Fed figures.

By Treasury’s own accounting, loans extended by the top beneficiaries of its $700 billion bailout fund have been practically flat all year.

But the administration and Congress, after castigating banks for months for not lending more, now seem resigned to a retrenchment in borrowing. Some political leaders echo the banks’ argument that it is more the result of consumers and businesses pulling back than banks being unwilling to lend.

Even the White House is portraying the lending collapse as a virtuous development, and says it wants a leaner economy less ridden with debt to emerge from the recession.

White House National Economic Council Chairman Lawrence H. Summers in a speech on Friday stressed that President Obama is determined that “the recovery from this crisis would be built not on the flimsy foundation of asset bubbles but on the firm foundation of productive investment and long-term growth.”

He said the administration will be patient as consumers, businesses and banks purge their debts, all the while acknowledging that cleaning up the mountains of bad debt in the economy will be painful and lead to an excruciatingly slow economic recovery.

“For quite some time, the United States will be living with the consequences of an overleveraged economy,” Mr. Summers said. “The common desire of households, businesses and financial institutions to reduce their borrowing and improve their balance sheets will act as a drag on spending and growth. While painful, these adjustments are essential to laying a sound foundation for future growth.”

Brian Gardner, Washington analyst at Keefe, Bruyette & Woods, sees a “a new attitude in Washington regarding financial institutions” in the wake of last week’s decision to let CIT fall into bankruptcy. It signaled that the administration is now confident enough to let the markets purge weak players and work out bad debts through bankruptcy and other market processes without attempting to save every borrower and lender, he said.

“Washington’s main focus is no longer the financial system,” he said. “The panic in Washington over the financial system has subsided and we think that is generally a good thing for the industry.”

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