Why taxpayers shouldn't have to bail out bad lenders

Savers really are being spoiled for choice with these government-backed banks now.

First Ireland, now Greece. And in the States, the $700bn bail-out package is back before Congress today (success is by no means guaranteed, of course and it's not clear the package would do that much to help anyway see here for more on the key provisions).

Trouble is, none of this is having much impact on the thing that really matters lending. In fact, credit market conditions are getting worse by the day.

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And as it becomes clear to everyone that we're facing recession no matter what, there's no reason that they should improve again any time soon, regardless of what governments do

The most recent US economic data is truly dreadful

Investors are in full-blown flight-to-safety mode. US economic data yesterday was dreadful. The number of people filing for new jobless claims hit a seven-year high. And meanwhile, factory orders fell by more than expected in August.

And yet, even as the Dow Jones index took another 300-odd point tumble an event so common these days it hardly seems worth noting the dollar pushed higher against the euro. Reserve currency status counts for a lot when people are scared, and right now they're terrified. For example, the gap between the Federal Reserve's target interest rate, and the actual level at which banks are lending to one another (three-month dollar Libor), hit a record high of 260 basis points (a basis point is 0.01%).

Meanwhile, the US commercial paper market shrunk by the most on record (since the Fed began keeping data in 2001), in the week to October 1st, falling by $95bn to $1,600bn. Commercial paper is short-term debt issued by companies to fund their day-to-day operations. "There is almost no area of the credit market or even of the banking system where companies are raising money," Tony Crescenzi of Miller Tabak tells the Financial Times. "A continuation of this trend would be problematic as the commercial paper market is where entities go to raise working capital to produce goods and services."

We're talking about a vital component of corporate cashflow here. So you can see why governments are so desperate to get the money markets moving again. However, there's a real problem becoming apparent.

Why banks have less and less incentive to lend

As it becomes obvious that this isn't just a "financial economy" issue (how anyone could ever have imagined that the 'financial' and 'real' economies are separable is beyond me), banks have less incentive to lend, even if their balance sheets weren't shot to pieces.

Take the housing market for example. British house prices have already fallen by more than they ever did in the 1990s crash, according to Nationwide, and show no sign of stopping. So why would anyone in their right mind lend money against property? Some banks are now only giving their best deals to those with 40% equity in their homes. But that's not blind fear that's good business sense.

And as we go into recession, the same goes for businesses. The message is getting through to all sectors of the economy that this downturn isn't going away, regardless of how many Chinese people want to upgrade their lifestyle. According to the FT, the FTSE 350 mining index is now down more than 50% from its high in May, and is now at a two-year low.

Lots of other companies are running into trouble. Marks & Spencer's sales slump was widely reported yesterday. But we also had chipmaker Wolfson Microelectronic, which makes parts for Apple's iPod among other things, reporting a sharp downturn in orders. And in the US, 'real' economy stocks from truckers to railways to agricultural groups all took a tumble. If businesses are also facing a horrendous downturn, then why would you want to lend to them either?

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So before governments take ever more drastic steps to backstop their banking systems, they should consider one thing what if things keep getting worse anyway? As I pointed out yesterday, Ireland's decision to guarantee its whole banking system looks a great idea until everyone else decides to copy it. As soon as investors start focusing on the creditworthiness of individual countries, rather than individual banks, the truly weak economies will find themselves in real trouble.

Iceland may regret nationalising its third-largest bank

Already Iceland's credit default swaps (a form of insurance against a party defaulting on its debt, though you're probably well aware of that by now) are pricing in the idea that the country may default on its bonds. It now costs €1.3m to insure €10m euros of Iceland's debt over five years. And that's after it nationalised just one of its banks, Glitnir. Basically, no one believes that Iceland can make good on its banking system's debts. As Bedlam Asset Management puts it, "it is impossible that the country can avoid the equivalent of Chapter 11."

We're in this position now because as has happened in credit booms since time immemorial - financial institutions have managed to become enmeshed with one another to the extent that when one goes, it takes out a whole big chunk of the web with it.

In the old days (and in less developed markets today, like China), you'd have comparatively transparent errors such as businesses all holding big equity stakes in one another. As long as the boom continued, they profited from each other's rising share prices, and when the bust came, they all exploded at once.

Pretty much the same has happened here, only it's much more difficult to see the links, because so many more parties middle-men are involved. But it comes down to one thing. Really stupid loans (mainly on property) were made, then sliced, diced, bundled, insured, re-insured, re-bundled, re-sliced, re-diced, insured again, and lapped up eagerly by a financial system full of people who believed that what they were buying would never, ever go wrong. The current bust is so appallingly bad because the risk from these loans has been spread throughout the entire system. And yet now, we want to spread it to the taxpayer as well?

We should be looking for ways to save 'real economy' companies

I know this opinion isn't popular right now. I know that even conservative commentators think "something must be done." But I don't think taxpayers should have their necks put on the line to save this system. It clearly doesn't work.

If banks are bankrupt, they should be allowed to go bust. Instead of worrying about saving the financial sector, if we're really worried about "Main Street" rather than "Wall Street", then why not look at ways to save 'real economy' companies whose main problem is simply not being able to borrow money?

For example, how about a Special Liquidity Scheme for any otherwise viable small businesses who are about to go to the wall because bankers are making them pay for their own mistakes by yanking away their lending facilities? Offering loans backed by decent business assets can't be any more dangerous than giving banks loans backed by shoddy collateral.

Given the choice, I know which assets I'd feel more comfortable about owning.

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