Jack M. Guttentag The Mortgage Professor

"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.