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Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

Maybe the Banks Should Be "Hoarding" Money

by Jack M. Guttentag

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Posted on Tuesday, January 13, 2009, 12:00AM

"Is it not shameful that our financial institutions receive capital infusions from the government and, instead of lending the money out, they hoard it?"

I hear this complaint a lot, and the government has not done a very good job of responding to it. My view of government intent is that the capital infusions were meant to be "hoarded," defining that word as adding to the firm's capital rather than adding to its loans.

A necessary backdrop: The financial crisis began in the home mortgage market and then spread like wildfire to engulf the entire financial system. The core reason for the conflagration was that financial institutions were over-leveraged -- meaning that their debt was excessive. They were also under-capitalized, which means the same thing.

The Major Roles of Capital

Consider a financial firm that has $100 billion of earning assets, $90 billion of debt, and $10 billion of capital, which is the difference between its assets and its debts. The major role of capital is to absorb potential losses on the assets, some of which will default. A closely related role is to instill confidence in the firm's creditors, whose concern is always whether or not capital is sufficient to absorb all losses. If it isn't, the firm may not be able to repay its creditors.

Let's assume the year is 2000 and the firm's assets consist entirely of home mortgages. Defaults and losses on the mortgages are very low because home prices are rising; the firm views its capital as more than adequate and it sets out to increase earnings by borrowing more in order to acquire more mortgages. It is increasing its leverage.

By year-end 2006, the firm has increased its assets and its debts by $200 billion, with no change in its capital. The $10 billion of capital must now cover losses from $300 billion of mortgages rather than $100 billion.

When the World Changes

That would not be a problem if the world didn't change. Indeed, the firm's expansion was based on just that premise. But the world did change: Home prices peaked and started to fall in late 2006, the default rate on the firm's mortgages began to rise, and everything pointed to continued increases in defaults and to substantial losses. Anticipating that rising losses could entirely deplete the firm's capital, creditors feared that the firm would not be able to meet its obligations.

Fast-forward to 2008, when some of the firm's existing obligations came due. The creditors involved would not extend them but insisted on being paid. Since the old creditors wanted out, there was little inducement for potential new creditors to take their place. Unable to raise new money to pay their debts, the firm faced bankruptcy, even before all its capital was depleted.

Enter the Government

Enter the government, which decided to make a capital investment in the firm. The purpose of the investment was not to provide the means for the firm to make more loans but to avoid the firm's failure and the devastating consequences of failure for the economy. The investment increased the firm's capital, which strengthened its ability to meet future losses and hopefully restored the confidence of its creditors.

Sometimes such investment decisions by the government have to be made very quickly, perhaps over a weekend, because the firm faces cash needs that it won't be able to meet when it opens for business on Monday.

In other cases, the need is not imminent but may arise in the future, probably when some debts come due. Many if not most financial firms are under-capitalized by the standards of today's harsh economic environment. A capital infusion from the government gives them a safety margin going forward.

A Misguided Reaction

It was reported on December 22, 2008, that the Associated Press had asked 21 banks that have received capital infusions of $1 billion or more from the government to report exactly what they have done with the money. None gave specific answers, which has been widely viewed as evasive and shameful. This is an understandable reaction, but it is misguided.

A bank‘s sources and uses of funds are like a bathtub with multiple pipes and drains. If a bathtub has water coming in from pipes A, B, C, and G (for government), and leaving through outlets W, X, Y, and L (for loans), the question of which outlet the water coming in through pipe G empties into is not answerable. Even if the tub were rigged so that the G inlet was connected directly to the L outlet, the allocation of water from the other sources to the various uses is bound to be affected.

It would be a simple matter, for example, for a bank to allocate 100 percent of the government's capital to various categories of loans while reducing the flow of funds from other sources into loans. We should be pleased that none of the banks have seen fit to play that game.

Besides which, the premise of the AP survey is wrong. The justification for the capital infusions is that it will increase capital, not loans. The goal is to avoid future shocks arising from the failure of under-capitalized firms. The fundamental purpose is to prevent the crisis from getting worse. Other measures are needed for a cure.

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252 Comments

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  • Yahoo! Finance User - Monday, January 19, 2009, 7:06PM ET  Report Abuse

    • Overall: 5/5

    great what about the minority shareholders in these banks - that played by the rules of opting to take and keep their savings in their 401ks

  • Yahoo! Finance User - Monday, January 19, 2009, 11:23AM ET  Report Abuse

    • Overall: 1/5

    Jack is lost, the money should go to the people - we are getting stuck paying for all these Bailouts - that aren't working.

  • Yahoo! Finance User - Monday, January 19, 2009, 9:42AM ET  Report Abuse

    • Overall: 1/5

    What's the point of bailing out all these banks when the culprits are not punished? History will simply repeat itself.

  • Yahoo! Finance User - Monday, January 19, 2009, 7:58AM ET  Report Abuse

    • Overall: 2/5

    jack needs to talk to joe the plumber. if we increase the flow into the bathtub from one source by x amount it is simple to measure how much of that increase flows out at each of the outlets, and also how much new inflow from other sources was induced by this change. face it, the banks are simply funding status quo and waiting for external events to improve the economy.

  • Yahoo! Finance User - Sunday, January 18, 2009, 4:15PM ET  Report Abuse

    • Overall: 1/5

    Firstoff, Let's examine Jacky Boy's Resume.... Jack M. Guttentag, former Jacob Safra Professor of International Banking at the Wharton School of the University of Pennsylvania, has been a student of the home loan market for many years. He has also served as a consultant to many government agencies and private financial institutions, including the Department of Housing and Urban Development, USAID, Freddie Mac, the World Bank, J.P. Morgan Securities, and many others. In addition, he was a director of the Federal Home Loan Bank of Pittsburgh and Guild Mortgage Investments as well as managing editor of both the Journal of Finance and the Housing Finance Review. Throughout his career, Professor Guttentag has been concerned with the difficulties faced by consumers in the home loan market. In 1985, he founded GHR Systems, Inc., which developed a nationwide electronic network that lenders use to deliver complex mortgage information quickly to loan-officer employees, mortgage brokers, and consumers on the Internet. It looks to me Jacky Boy that you are te only one who has gotten his share of the TARP money because I haven't gotten any of mine for paying my mortage every month....How much did Freddy and FANNIE pay you last year???? YOU ARE A FRAUD

  • Yahoo! Finance User - Sunday, January 18, 2009, 12:47PM ET  Report Abuse

    • Overall: 5/5

    A very articulate explanation that although simplistic (obviously - its an article, not a treatise on recapitalisation) captures the essence of where the immediate problem lies. And please - the number of commentators who blame policticians, bank management, political parties etc. Its not that straightforward - there arent black hats and white hats in this movie. Just look at the brass tacks - money doesn't evaporate, for every loss that a bank suffers, there is a winner. So where are the winners? It might not feel like it right now, but every, single individual, company or tenant who fails to repay money that they have taken from a lender is a winner - add them all up from the mortgage industry, and thats who has the money. Reckless lending yes, reckless borrowing yes - so please, no more finger pointing because most of us only have 10 and that 'aint enough.

  • Yahoo! Finance User - Sunday, January 18, 2009, 11:14AM ET  Report Abuse

    • Overall: 2/5

    What truly galls me is the fools saying we couldn't have seen this coming...I sold my house ,and got out of home builders in 2006. When the insiders at KB homes were selling hundreds of million of insiders shares, while B. Corcoran, and S Zell, Trump, were selling off their RE holdings, while BOA was offering mtg. loans to admitted illegal aliens, while the head of the NAR was retiring......no, who could have saw this coming...sheeesh. Now if I can just persuade my friends in bonds to look at what's happening there...no bubble?...but what's a few hundred billion or a few trillion amongst friends?..... indeed.

  • Yahoo! Finance User - Saturday, January 17, 2009, 8:04PM ET  Report Abuse

    • Overall: 1/5

    First of all, for those unsophisticated mopes on here who say it was Bush's fault for this are simply uneducated and know nothing of what truly happened. Please, don't let the facts get in your way. Fact is that the Democrats are to blame for this fiasco. They absolutely insisted on turning a 1 page list of what was to be done with the money into 673 pages of nitpicking oversight. Pelosi, Reid, and Frank are to blame because they Sooooo wanted accountability for the money but when it came time for the answers to where the money ended up the three stooges bucked up, threw their hands in the air and said "it was Bush's fault". That ain't what happened. The entire amount was basically misappropriated and all of the oversights were never double checked, cross referenced or held accountable. This absolutely falls in the laps of the Dem's whom, by the way are the one's who caused the problem in the first place. Right Barney Frank? This fat slob of a joke made a killing of Fannie and Freddie yet still gets to keep his job and then point the finger at other people for monster that he himself created. By the way, Jack Gootentag doesn't have slightest clue what he's talking about in this segment. He's playing smoke-n-mirrors with you so don't believe a word of it. This isn't what happened with the money or why it isn't available as credit. How does this crap get published?

  • Yahoo! Finance User - Saturday, January 17, 2009, 2:42PM ET  Report Abuse

    • Overall: 1/5

    This Hack works for the Banks as a Lobbyest. He lobbyed hard for his bank buddies to get the sleazy mtg programs from Wall Street. Jack the Hack is the reason why were in this mess now!

  • Yahoo! Finance User - Saturday, January 17, 2009, 11:34AM ET  Report Abuse

    • Overall: 5/5

    Straight to the point in layman's language. I have a new perspective. Thanks.

  • Yahoo! Finance User - Saturday, January 17, 2009, 8:16AM ET  Report Abuse

    • Overall: 5/5

    I usually give Ben Stein my only 5 star ratings, but I liked this article. The author has used simple terms, which are always best for broad explanantion. Truthfully, I still don't get the bathtub deal! But I do understand capital and in a way one could argue the government killed two birds with one stone by infusion of capital (cash) into the banks. One, the banks effected are now properly (or better) capitalized. Second, the banks now have money to deal with the defaults to come. If the government had followed their original plan of buying "toxic assests", it would have been the same money (government money) taking the hit on the defaults. This way the banks have the money for the potential forclosure loses and they are better capitalized. If you like my reasoning, kindly lobby Yahoo for a chance to post on why it is the real estate industry's fault, for the most part, in causing this debauchle.

  • Yahoo! Finance User - Friday, January 16, 2009, 11:24PM ET  Report Abuse

    • Overall: 3/5

    I'm rating this 3 stars not based on whether I agree with his comments, but based on his presentation style and coherence. A lot of people rail against the banks and Government, but everyone should be looking at those who bid up real estate in places like San Diego, Los Angeles, San Jose, and Las Vegas. The collapse of real estate in these places (and not most other U.S. cities) is what hurt the banks.

  • Yahoo! Finance User - Friday, January 16, 2009, 3:35PM ET  Report Abuse

    • Overall: 1/5

    Whatever you do - DO NOT TRUST THIS GUY. He is part of Big Business' mis-information campaign. The purpose of giving taxpayer money to banks was not so that they could pay out billion dollar bonuses to the CEO and sit on the rest of it. The money was intended to circulate - like giving a blood transfusion to a dying patient. It was supposed to *CIRCULATE* throughout the patient's body (i.e. the US economy). Circulation means letting that money flow back out into the economy by offering loans to people so they can refinance the loan on their house, take out a loan to buy a new car, take out a loan to buy new equipment for their small business - i.e. to stimulate the economy and create jobs. Just Google this Jack Guttentag character and you'll quickly find that he is a highly-paid consultant for Citigroup and Bank of America -- just one more lobbyist on the corporate payroll. The only thing I don't understand is why Yahoo has given him a platform to spread his lies.

  • Yahoo! Finance User - Friday, January 16, 2009, 3:22PM ET  Report Abuse

    • Overall: 2/5

    I must say, the authors view is very well thought out and well articulated, but he lacks real long term outlook. Without incoming revenues, hoarding the monies will only float them for so long. If these banks do not use these funds to produce new performing accounts, ultimately they will fail. With the demand for mortgages all but gone, perhaps they should look into better performing products like Unsecured Loans which require A borrowers and have more stringent underwriting guidelines.

  • Yahoo! Finance User - Friday, January 16, 2009, 12:25PM ET  Report Abuse

    • Overall: 3/5

    Come on! Give me a break. The banks know where the money lent to them went. If you give me a $20 billion line of credit, I can do wonders too. But, I'm not a beholden bank. It's all the fault of Paulson/ Bush and company. They sold the idea that if the banks folded, we all would be worse off. Let them go broke, them bastards because they'll never get out of the hole. Give me the money, not to them.

  • Yahoo! Finance User - Friday, January 16, 2009, 12:03PM ET  Report Abuse

    • Overall: 2/5

    This would be all good if the outrage was not of a different nature. Basically, the lack of transparency on use of the TARP money highlights the fact that the case has still not been made on why the capital investment by government made sense in the first place. Would it cost the taxpayer more to let the glorified free markets ran their course and let the insolvents like probably Citi and possibly also Bank or America are, go out of business. Or nationalize them altogether so that at least the taxpayer knows they're not just handing out money to people who have proven to not know how to run their business (vs. say JPMorgan chase who still reported a 4th quarter profit yesterday). My house is paid off. I have fixed income that's not been affected by any of this. Many like myself really couldn't care less if business failures like those banks who partook in the lending frenzy took their well deserved hit. Instead we're looking at future inflation to erode our assets and income, while supporting private institutions in a socialist fashion. The cure is to cut the dead branches now, not keep throwing good money after bad. Why is it ok to take money out my hoard (savings) to give it for banks to hoard? All we heard is boogieman stories about how much worse it'd be if we did let them fail. It's pretty bad already and we're just that much poorer for it in future obligations. The reaction of most people is that the lack of transparency and the bank hoarding is just the cherry on top of the stale cake that's being shoved down our throats. It won't go down easy no matter how righteously anyone tries to sell it to us.

  • Yahoo! Finance User - Thursday, January 15, 2009, 10:41PM ET  Report Abuse

    • Overall: 2/5

    Jack, we were told that the TARP money would be used to buy up toxic assets and equity from financial institutions in order to strengthen up the financial sector. The banks themselves should not have increased their amount of assets and debts without an equal percentage of capital to protect themselves from defaults. In the business world this would be called covering your a$$. Instead, this money is being taken from the hard-working taxpayer who is already tapped out with excessive taxes (federal and state income taxes, property taxes, sin taxes, etc...). If any other business were to operate in this manner they would be doomed to reap what they sow. But, why not the financial institutions? It can't be because they are too big to fail. In a free market, there would be a bank willing to take its place in line. Maybe they are being bailed out because they lobby the most money to the Republican and Democratic parties? My solution would be to let these banks fail. Yes, it would be very painful for a while, but it's like Peter Schiff said - You don't cure a heroin addict by giving him more heroin, he has to go through a painful withdraw. My next step would be to end the Fed and fractional reserve banking. Since when does a capitalist market have a central bank? Lastly, the only thing the government should be doing is protecting the rights of the US citizens as described in the US Constitution.

  • Yahoo! Finance User - Thursday, January 15, 2009, 7:19PM ET  Report Abuse

    • Overall: 3/5

    If we were encourgaged to jump off a bridge would we do that too. The idiots who took out bad mortgages, 2nd and 3rd mortgages, and crazy credit card debt are just as guilty as the banks. Pay for your car and big screens dont go into debt. There is plenty of blame to go around, what we need is a solution.

  • Yahoo! Finance User - Thursday, January 15, 2009, 6:49PM ET  Report Abuse

    • Overall: 3/5

    While the analogy is decent enough, and the explanation is most helpful to Joe Everyman, the fact of the matter is people still have a right to be more than just angry. We too were encouraged to over leverage, and take on mortages high end cars, and flat screen TV's by using credit cards--pipe/drain A,B, C and G, and it certainly affected our water level too! Sadly you are correct--the Banks are viewed as valuable bathtubs which must be bailed. --We the tax paying consumer, however, are viewed as The Toilet---and we are being flushed accordingly.

  • Yahoo! Finance User - Thursday, January 15, 2009, 6:36PM ET  Report Abuse

    • Overall: 3/5

    Interesting related article: http://www.euromoney.com/Article/2060532/Inside-Investment-Bring-out-your-dead.html

  • Yahoo! Finance User - Thursday, January 15, 2009, 6:17PM ET  Report Abuse

    • Overall: 2/5

    They are not hoarding they are buying out the banks who really needed the bail out money. The government is only giving the bailout money to the banks who really could have survived without the infusion of cash. The banks who needed the money are left to scramble to get bought up and no money is allocated for them, it just seems bassackwards if you ask me. It like giving a family member money to payoff their mortgage and they take the money and buy and investment property because they never needed money to pay their mortgage. As far as the cause for this crash of financial institutions it is indeed over extention of debt just like the people that they gave mortgages too. The problem is that these banks are lending over ten times the amount they have on deposit. They were supposed to be regulated to not lend more then 10 times their deposits but these regulations seem to be more of a suggestion then a law. So is it fair for taxpayers to pay interest to get a loan from a bank if they make that loan from money that we the tax payers gave them?

  • Yahoo! Finance User - Thursday, January 15, 2009, 4:33PM ET  Report Abuse

    • Overall: 1/5

    The premise of Mr. Guttentag's argument is wrong, and suggests why providing any money to the big banks is a useless adventure. The banks are hoarding money because they are required to carry a certain percentage of their assets in cash to cover losses and withdrawals. If their actual available cash drops too low they are in violation of certain banking rules and can be taken over by the Feds (commercial banks, not investment banks). However, this ignores that they still have a lot of very bad loans on their books. If those loans go into default in high enough numbers then the reserve will not cover the losses, and the bank will be bankrupt - out of business. The banks are coming back for more money because they are seeing much higher rates of foreclosures than expected. Problem is, that this is just good money after bad. The banks keep showing those weak assets at full value, when they are probably 40% or more below book value. That type of loss cannot be covered by the Fed or Tarp - just not enough money. So they hang on to the illusion that there assets are at one level when they clearly are not, and build up their cash reserve for the inevitable crash. They will survive, the home owners will lose everything, and the government will lose its entire Tarp investment. The only solution out of this predicament is to get the economy going. For banks, that means making good loans and then reselling those loans to investors so they can make more loans ad infinitum. Hoarding the relatively small sums provided by the Feds, so the executives can get bonuses just makes things worse. It is a lot like priming a well, but drinking the priming water, because you are afraid the well will not produce. The banks have to prime the well, they have to make loans, because if they don't the well will never produce anything. And the U.S. economy will slowly sink into a long term deflationary depression.

  • Yahoo! Finance User - Thursday, January 15, 2009, 4:31PM ET  Report Abuse

    • Overall: 1/5

    Jack, you are an Intellectually Imputent Morron!! You speak of Government Capital as if it were a Christmas Card from Grandma with money in it!! Get a clue, the only money the government recieves comes from the working taxpayers. You can't name one sector that the Government runs that has a surplus or turns a profit!! It ain't Social Security, It ain't Medicare of Medicade, and it certainly AIN'T Fanny mae or Freddie Mac! For all the shortcomings of the Government though, the blame rests on the idiots that vote the Socialistic Sabateurs into office. Those that fail to observe history, are doomed to repeat it, and If you can't identify Socialism, you can't protect yourself from it are 2 of my favorite quotes. Chew on that you Morron

  • Yahoo! Finance User - Thursday, January 15, 2009, 4:06PM ET  Report Abuse

    • Overall: 2/5

    Jack, you provide a simple enough explanation, but don't you think the change in the accounting rule had some effect? The "mark-to-market" rule certainly caused the asset values to plummet as a result of the manipulation of the ABX index and the drying up of the MBS market. And here's another missed opportunity: Why couldn’t the banks re-value their assets based on what the government was willing to pay for them when the original TARP plan was initiated? If that not a market, what is? No, said Paulson, just wouldn't work as well as buying stock or a direct infusion. What baloney! The culprits: Bush, by stupidly encouraging deregulation, equating it with a free market; The SEC, by making sniffing Wall Street’s ass their fulltime job (example: they created the "Madoff Exception" --no joke, look it up-- for option market makers that allows them to naked sell equities they don't own and also to rent out their access to this powerful tool to the highest bidder), and Hank Paulson himself, when, as the head of Goldman Sachs, created and then blatantly manipulated the ABX index, which is used as the basis for the rating/valuation of MBS assets and their derivatives. In the face of such overwhelming systemic corruption, incompetence, and lack of oversight, I’m beginning to have trouble remembering what, exactly, makes this country so great. Sorry… off topic.

  • Yahoo! Finance User - Thursday, January 15, 2009, 2:39PM ET  Report Abuse

    • Overall: 1/5

    Jack this shameful. Your article ignores that the money/capital infusion that these institutions received came from the TAXPAYERS. Name one of these institutions that have taken any steps to reward tax payers for foot this bill. They are in full flight panic mode. These guys have reduced the credit available to credit worthy borrowers, increased premiums on distressed consumers, employ the same lending strategies (albeit to credit worthy buyers) that got them in trouble,and curtail lending to viable businesses. Some of these institutions are leeches and should not get a dime of Tax payers money.

  • Yahoo! Finance User - Thursday, January 15, 2009, 2:25PM ET  Report Abuse

    • Overall: 5/5

    What are the names of the 21 banks who received at least 1-billion dollars in TARP funding?

  • Yahoo! Finance User - Thursday, January 15, 2009, 2:20PM ET  Report Abuse

    • Overall: 4/5

    Great explanation. I wish you would have mentioned fractional reserve banking and how lower reserve requirements factored into the problem. If we eliminated fractional reserve banking, we would never have bank runs and our money would be honest instead of being nothing but IOUs.

  • Yahoo! Finance User - Thursday, January 15, 2009, 1:29PM ET  Report Abuse

    • Overall: 3/5

    We are a group of physicians owning multiple medical office parks in central Florida, and wanted to borrow a commercial loan in order to expand one of our sites. The biggest banks including 5/3rd and Bank of America were not interested in loaning us the money if it wasn't 50% owner occupied even though our debt to capital ratio is 5%. I don't know how many commercial construction is going to happen with owner occupancy of 50%. The banks are holding on to the money, and that'll kill this economy. The feds should have started their own bank, and bought a bunch of small local community banks that are uneffected for the most part by these toxic mortgages. This way businesses wanting to start or grow would have an alternative bank to go to when the private banks refuse to lend them money.

  • Yahoo! Finance User - Thursday, January 15, 2009, 1:09PM ET  Report Abuse

    • Overall: 5/5

    Thank God someone's out there who isn't knee-jerking in response to this whole mess. Well said Jack! As far as "other measures are needed for a cure," however, I seriously doubt that anything can possibly cure this widespread collapse - or for that matter, even prevent it from getting worse. I'm guessing that preventing an outright, absolute collapse is the best case scenario, and that a painful decline will continue for at least a couple of years no matter how much the government intervenes. The hope is that they can maneuver our descent into a more gradual slope rather than a steep one. Global deleveraging is a natural process that must be managed, not prevented.

  • Yahoo! Finance User - Thursday, January 15, 2009, 12:00PM ET  Report Abuse

    • Overall: 4/5

    Nothing wrong hoarding the money and collecting the interest and build capitol assets. Besides, who the hell out there is worthy of a qualifing for a significant bank loan these days. Jeez!

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