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Business Costs & Regulation

Beginning of the End
For Economic Rescue

Federal regulators will find getting out is much trickier than jumping in.

From Treasury to the Federal Reserve, with many other agencies in between, regulators will attempt a financial high wire act in 2010, trying to gradually end a period of extraordinary federal intervention in the economy. Last year, the economy relied on the skill of government officials to navigate troubled waters. Banking regulators jumped in with both feet when the financial crisis hit in late 2008 and followed up with scores of additional steps in 2009. Soon they’ll have to start the withdrawal process.

Growth in the coming year will hinge in no small part on the ability of officials to chart a cautious course out of those rescue programs, which have kept lending markets from shutting down. If government pulls back too quickly or too slowly, it could have a devastating effect, either snuffing out a nascent recovery or bringing on a dangerous round of inflation.

The Federal Reserve has the trickiest role. In addition to buying credit card, auto and SBA loans from banks to spur more lending, it has propped up fragile housing markets by purchasing mortgage debt. That’s kept interest rates below 5% on fixed loans. “The Fed needs to be very careful,” says William Isaac, former chairman of the Federal Deposit Insurance Corp. and managing director at LECG, a consulting firm for financial institutions. “When you put a person on a respirator, it’s tough to get them off,” Isaac says.

The Fed’s goal is to stop buying mortgage backed securities by March 31, but odds are that date will slip. The Fed wants more signs of recovery before it pulls out. When it does, mortgage rates may rise a full point, threatening to kill the growing appetite for home loans.

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Whatever the Fed does, Washington will still dominate the housing market. It’s likely to take several years before private investors show any interest in mortgages or mortgage backed securities. “The market is dead,” says Robert Litan, vice president of the Kauffman Foundation and a fellow at the Brookings Institution. “No one wants to buy private-label mortgages now.”

That means Fannie Mae, Freddie Mac and the Federal Housing Administration must bear the brunt of the housing loans on the market. Housing’s slow recovery will delay any reform of Fannie and Freddie, which became government wards more than a year ago. They cost taxpayers $291 billion in 2009, and Treasury promises unlimited backing to meet their needs through 2012. Come February, the administration will propose remaking the agencies into something like a public utility, with caps on profits and explicit federal backing of their debt.

The banking industry also has a way to go before it can stand on its own. “Most banks are looking at 2010 as a year of recovery,” says Isaac. “It’s not going to be a year of record earning profits, though.” The big banks that got loans under TARP are repaying the government to get out from under the federal microscope. But the industry is still getting other aid, including the ability to borrow money at near-zero interest rates, which will continue for months.

Small banks won’t fare as well as their bigger competitors over the course of 2010. “Unlike larger banks, small community banks will be shut down if they can’t cover their credit losses,” says Mark Calabria, director of financial regulation studies at the CATO Institute. So far, about 10% of banks have repaid all or part of their TARP loans back to Treasury. But they will continue to struggle because of their exposure to commercial real estate loans, where defaults and foreclosures have yet to reach a peak. Some 200 small banks will go under in 2010, up from 140 in 2009. “A lot of smaller banks will be hit with a one, two punch,” says Calabria.

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Resolving those failures will keep the FDIC busy in the coming year. But emergency support from the agency will soon be gone. Temporary guarantees of interbank lending were extended to April 30, but only in a crisis and for a fee. Meanwhile, an extension of the deposit guarantee ceiling to $250,000 will be made permanent before it expires in 2013.

As unemployment persists and the economy experiences only tepid growth, President Obama will keep pressuring banks to lend more to small businesses. But banks won’t be in a position to do too much. That’s because they are also getting squeezed by regulators worried about banks taking on more bad loans. Getting the balance right between lending and stability “is a delicate task,” points out Isaac, who helped handle the savings and loan crisis two decades ago. “Regulators have to be careful about winding down.”

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