The stock market seems to be rallying on the idea that Chairman Bernanke’s rate cuts will deliver a quick end to the recession. But you have to wonder if the extra money injected into the financial system will do much good when you consider that bank balance sheets are guaranteed to soak up a huge portion of it.
Banks have simply burned up their cash on real estate speculation. A bank with gigantic losses can’t make new loans - even to people with good credit ratings. Bernanke will loan money to these stupid bankers to make them whole again, but the banks will have to pay interest on those loans. So, even a bailout is no free lunch because the banks will still be in a weakened state. The new money injected will not flow right out into the economy in the form of new loans. If the banks can increase their loans, they will still have to be selective because of the extra interest they have to pay to Bernanke.
How much money will Bernanke have to loan to the bankers before they are whole again? There is probably no way of knowing that yet. For two years now, the bankers have been pretending that everything is just fine while announcing more and more write-downs. They don’t want to fess up, and only do so when forced to.
Suppose you inherit a million dollars from a rich uncle, and deposit it into your savings account. Now imagine that your bank loans it to a real-estate speculator in the form of a “liar loan”. The speculator then buys a million-dollar house, which subsequently falls in value by half.
Half of your money is now gone, but does your bank send you a letter to inform you of the sad fact? No. They act like everything is just fine while they scramble around trying to “acquire new assets.” They need to borrow $500,000 to become solvent again, but it’s a tough sell because they have proven themselves to be poor bankers, and possibly a bad credit risk.
Bernanke would loan your bank the money, but your bank doesn’t want the stigma of having to be bailed out. So the scrambling for loans is still going on as indicated by last week’s jump in the Libor rate. If you can’t read this Wall Street Journal story, the gist of it is that Libor rates have jumped because banks have been lying about the rates they have been paying for loans made to them by other banks.
It’s a stigma to get bailed out by Bernanke, and it is also a stigma to borrow money from another bank at a high rate. The higher the rate that you have to pay, the lower your reputation as a banker goes because it indicates that you are a poor credit risk.
Bernanke has lowered rates to 2.25%, but the Libor rate is now almost 3%. Bernanke wants banks to be able to make loans to each other at 2.25%, but bankers are only willing to loan to their deadbeat brethren at 3%. Bernanke wants rates down, but the market is not co-operating.
A higher Libor means that the recession will last longer. Not only will it cost deadbeat bankers more to get solvent again, but zillions of loans are indexed to Libor - including sub-prime mortgages. The market has revoked 0.75% of the savings that Bernanke has tried to give to sub-prime borrowers due for resets.
Of course, there has never been a case where the Fed’s interest rate cuts have failed to stimulate the economy. However, every recession is different, and this one began with giant holes in bank balance sheets. The stock market rally shows that investors are counting on a short-and-shallow recession, but the Libor jump shows that things are not going according to plan.
