Bailouts That Are More Trouble Than They're Worth

The New York Times reports that some banks are ready to give back their bailout money because of the multiplying strings attached to it, including limits on executive compensation, dividends, employee training, local philanthropy, and hiring of foreign citizens. Critics worry that "the conditions go beyond protecting taxpayers and border on social engineering." The most troubling complaint is that the government is pushing banks to make risky lending decisions that will undermine their profitability and stability:

The demands to modify mortgages or forestall evictions are especially onerous, some bank executives and experts say, because they could prompt some institutions to take steps that could lead to greater losses.

"We are taking an approach that wants the banks to help the economy and whether it is ultimately good for a particular bank is secondary," said L. William Seidman, the former senior regulator during the savings and loan bailout. "Weak banks are being asked to do things that will erode their position."…

A growing chorus of industry experts are warning that asking weak banks to carry out the government's economic and social policies could increase the drain on the public purse. These experts say that the financial assistance, while helpful in the short run, could force weak banks to engage in lending practices that will lose even more money, and that the government inevitably will become more heavily involved in dictating how banks do business.

The bailout conditions could not only contribute to bank failures; they could help set up the next boom-and-bust credit cycle by encouraging the sort of reckless lending practices that contributed to the current one:

Take Fannie Mae and Freddie Mac, the housing-finance companies that the government now controls. In recent months, they have been told to spend billions of dollars buying bundles of mortgages for which there are no other buyers, and to let homeowners refinance their loans—even if they have no equity.

Such commands are echoes of the 1990s, when Fannie and Freddie tried to balance dueling mandates that required them to make a profit for their shareholders and to serve a public mission of increasing homeownership.

In service of both shareholders and what they asserted was the public good, they borrowed extensively in order to buy and hold mortgages in their own investment portfolios. They purchased billions of dollars in risky subprime mortgages.

As a consequence of having a public mandate, they also had a credit line with the Treasury and their risky business strategies were viewed by the markets as being guaranteed by the government.

To satisfy both mandates, the companies also faced fewer restrictions and were allowed to take on more debt than other financial companies. But when buyers began defaulting and home prices plunged, the companies nearly collapsed and last fall were placed under government conservatorship. [Brookings Institution economics fellow Douglas Elliott] said that some banks participating in the bailout program are now in the same conflicting position that Fannie Mae and Freddie Mac were in.

[Thanks to Tricky Vic for the tip.]