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It’s also worth noting that interbank lending froze completely when the bailout was announced. Why take the risk when Washington can force taxpayers to take it for you?
Nor are such programs likely to stave off massive job losses. In a 2003 speech to the National Economists Club in Washington, D.C., then–Federal Reserve Governor Edward M. Gramlich argued that loan guarantee programs are unable to save failing industries. Lack of access to credit markets is caused by serious industrial problems, he explained, not vice versa. If an applicant’s business plan cannot be made to show a profit under reasonable economic assumptions, private lenders are unlikely to issue a loan.
Then why is the federal government still guaranteeing loans? Because it serves two powerful constituencies: lawmakers and bankers.
Politicians love loan programs because they’re a wonderful way to reward interest groups while hiding the costs. When the programs are established, the mathematical certainty of future defaults and their potential effect on the deficit are never considered. It’s like buying a house on credit without having a trace of the transaction on your credit report.
But the true beneficiaries are lenders. Take small business loan guarantees. When a small business defaults on its obligation to repay a loan, bankers do not bear most of the cost; taxpayers do. Meanwhile, lenders make large profits on SBA loans by pooling the guaranteed portions and selling investors trust certificates that represent claims to the cash flows.
How profitable is this? Testifying before Congress in April 2006, David Bartram, the president of the SBA Division of U.S. Bancorp, the nation’s sixth-largest financial services company, explained that “return on equity of SBA loans can exceed 70 percent.” A 70 percent return on equity (RoE) is remarkably high. Right now, the five-year average RoEs for the two biggest banks in America—Citigroup and Bank of America—are 16.2 percent and 14.5 percent, respectively.
For years, banks have reaped the profits from loan guarantees, whether for small businesses or homeowners. Now that the skim has been exposed, taxpayers, not banks, are asked not only to pay the cost of the defaults but to bail out the irresponsible lenders. And the government has decided to encourage more lenders to take more chances by guaranteeing yet more loans to high-risk borrowers. The only guarantee for these loans is that our children will be paying billions to cover the losses.
Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.