Thursday, July 16, 2009

The Wall Street Bailout Was Never About the Banks or the Economy

When the Wall Street bailout was first proposed, and then-president George W. Bush was talking about the possibility of “blood on the streets” and martial law if it didn’t pass Congress, the Treasury trotted out a story about a payday loan. Quotes from an anonymous, probably fictional business owner described how their “small” business would probably not be able to get a payday loan to pay its workers and might be forced to shut down if the Wall Street bailout did not pass.

I don’t know if anyone believed that story, but it is now safe to say that the Wall Street bailout was never about jobs and the economy. If it had been, then CIT Group, which does more of these short-term “small business” loans than any other lender, would be the perfect candidate for the bailout. Instead, last night Washington told CIT to go ahead and file for bankruptcy if things get worse.

The CIT saga also casts doubt on the premise that the Wall Street bailout was intended to protect the banking sector from systemic risk. CIT’s experience is all about systemic risk. It is no accident that the run on CIT happened just weeks after Advanta, which had provided credit cards to many of the same borrowers, shut down its operations. Customers (mostly small corporations) that couldn’t buy supplies on their Advanta card anymore, or that wanted to pay off their final Advanta card balance, borrowed from their CIT credit lines. Then other borrowers, worried about CIT’s financial condition, took extra money out of their credit lines. It is not the exact pattern of a classic run on a bank, but it is not different in any important way.

A bank closure, ripple effect, a run on another bank. If a third of the banks in the United States are going to topple, this is exactly how it will happen.

The ripple effect certainly will not stop at CIT, which now may be forced to suspend most lending so it can have the cash to pay its bills. If CIT files for bankruptcy, the bankruptcy court may have no choice but to order many of its borrowers to repay immediately. This could drag a few thousand of those borrowers, including several retailers you have heard of, into bankruptcy, which in turn will affect other lenders. Meanwhile, businesses that can no longer borrow from CIT will rush to get loans elsewhere, probably leading to an increase in business loan interest rates everywhere. With the higher interest payments, there are more defaults, more problems for more banks, and it goes on from there.

If the Wall Street bailout was not about the economy and was not about saving the banks, then what was it about? It could just have been someone’s crazy idea. But if you start to draw a diagram of all the people involved, with lines to indicate who knows who, you have to start wondering if the whole idea was just money for Wall Street all along.