Friday, March 13, 2009

This Week in Bank Failures

Banks and cardholders alike are canceling credit card accounts. The Wall Street Journal estimates $5 trillion in total credit card lines of credit in the United States, after that total was reduced by $500 billion in the fourth quarter. Most of the reduction must come from banks closing inactive accounts, but there is more going on than that.

The major banks are seemingly conspiring to raise the default interest rate on credit cards to 30 percent, and the prospect of possibly paying 30 percent interest, along with other, more onerous changes in terms, is leading cardholders to cancel accounts in large numbers. As one cardholder described the process to me, “It’s like the bank is saying, ‘We don’t want you around here.’”

Banks are cutting back on credit cards to reduce their exposure to the now-risky U.S. consumer and small business. The effect, though, is to reduce liquidity across the whole economy. People can’t spend as much because they don’t have as much money available, or because of the tremendous financial risk that a late payment on a credit card now implies. The ironic result of this is to increase the rate of defaults on home mortgages and business loans. With less liquidity, even a small disaster, such as a car breaking down, can result in a late loan payment.

With less liquidity, people have to cut back on their spending, and that is probably the main reason why the U.S. savings rate suddenly shot up to 5 percent after hovering near zero for a generation. “Savings” could mean putting money in the bank, but in this situation refers mainly to people paying down loans while not taking out new loans.

It is not that people have suddenly become savers, but that banks have suddenly stopped lending. The Wall Street bailout, which was supposed to spur new lending, has had the opposite effect. Banks are lending less and relying more on government handouts.

At the same time that banks have lost trust in consumers and businesses, people have lost trust in the banks. With so many stories of borrowers seemingly being cheated by banks, people are reluctant to put enough trust in a bank to take out a loan. The shock value of some of the new credit card terms is adding to the atmosphere of mistrust. People who had never before thought to question a bank are now doing so after feeling insulted or put off by unexplained changes in their accounts. And so, if banks were to change their minds and decide to start lending again, it is not as if consumers would be lining up at their doors. The large level of debt that most households and businesses have taken on will have to be paid down to a much lower level before people start feeling comfortable again.

Banks, of course, are happy to have borrowers pay back loans, but when that becomes a national obsession, it is not good news for banks. Lending is the core of the banking business, and if there is no nearly so much lending to be done, then there is not so much banking to be done. Some banks are set up to make a small profit from their other operations, but others are deeply dependent on lending to make a profit.

And banks need to start making a substantial profit again to dig themselves out of the various financial holes they have dug themselves into. Any bank that received Wall Street bailout money needs that profit just to pay the dividends on the Treasury money they are holding. The money to pay those dividends will have to come out of the bank’s profit from lending. And the dividend payments are not as optional as they might seem; a bank that fails to pay its Treasury dividends is a few short steps away from being nationalized or shuttered. Therefore, a bank cannot afford to start thinking of borrowers as the enemy. Yet that is what most of the large banks in the United States are now doing.