Why U.S. banks need to pull back from lending

U.S. banks need to stop the charade, ignore the political and public pressure and admit they're not lending. It's not because they don't want to, but because it's bad business.Don't think so? Take this pop quiz. On Monday, Bank of America Corp.(BAC : 8.02, -2.58, -24.3%) announced smashing profits for the first quarter.

Ken Lewis, the bank's chief executive, claims B. of A. is lending as if the good times never ended. So, in the bank's conference call, which one of the following statements did Lewis make?

A. "Credit is bad and we believe credit is going to get worse before it will eventually stabilize and improve."

B. "Even our internal economists are a little at odds as to the timing with some seeing recovery earlier (than year-end)."

C. "We believe unemployment levels won't peak until next year at somewhere in the high single-digits."

D. All of the above.

E. None of the above.

For a CEO whose bank is lending as if it's 2006, you might be surprised that the same Lewis who proclaims to be bullish on loans is bearish on the economy. The answer is D.There's only one problem. No bank CEO can reconcile more lending with a deteriorating economy -- especially one in which economic conditions are the worst than they've been in generations. But that's exactly the claim he's making. Lewis described a deep recession that's going to be here for months. Still, B. of A. touts that it's "helping" homeowners and small businesses with new loans. It claims to have added 45,000 customers and provided them credit. The reality, however, is less impressive: Bank of America loaned $183 billion during the quarter, up just 1.6% from the last quarter of 2008, when lending took a big dive industry-wide.

This isn't to single out Bank of America. All of the major big banks, including Wells Fargo Corp. (WFC:17.00, -3.26, -16.1%) , J.P. Morgan Chase & Co. (JPM:29.69, -3.57, -10.7%) and Citigroup Inc. (C:2.94, -0.71, -19.4%) have been doing the credit double talk that goes something like this: these are terrible conditions to be lending in, but we're lending in them without risk.

TARP as stimulus

If those claims sound a little too good to be true, it's because they are. Almost all the big banks that have taken cash from the Troubled Asset Relief Program have curtailed lending, according to The Wall Street Journal. See WSJ story.

One of the intentions behind TARP was for it to be a kind of stimulus program made through the banks. After plugging holes on each bank's balance sheet, the TARP cash was supposed to flow into new mortgages, auto loans, credit card lines and corporate lending. Six months later, it's fair to say TARP has helped prop up some banks, but it hasn't flowed into the consumer credit markets the way the framers intended.

Now, critics have argued that the banks should be loaning this money to help stimulate the economy. Companies need credit to expand and hire, they say, and consumers need credit to buy products and help feed the economy.

In almost any other economic time, this would be true, but not in a time where an over extension of credit created the recession we are fighting. Credit cycles by definition are periods where banks overextend credit and then pull back to correct the over extension. If the government forces banks to lend to at-risk borrowers, we're going to aggravate an already dire credit picture and require more government intervention.

You can easily see how lending to home buyers not worthy of credit would fuel the nation's housing woes and create more housing problems, but what about the loans most people assume are helpful to the economy: small-business loans?

It turns out that existing small-business loans are defaulting at an alarming rate. More than 4.4% of small-business loans were in 30-day default, up from 3.48% a year ago, 1.29% were delinquent 90 days, up from 1.04% a year earlier and 0.63% were 180 days delinquent, double the rate a year ago, according to Pay Net, a small-business payment network.It doesn't matter what type of loan, lending into an economic downturn is an invitation to trouble.

Government intervention

The steep rise in defaults and non-performing loans suggests that the economic conditions Bank of America's Lewis talked about will make it hard for banks to simultaneously set aside reserves and lend more money out. Small businesses will lay off workers before they start missing loan payments, and the unemployed can't pay off their credit cards and car loans.

Taxpayers fuming about the banks' unwillingness to loan government money into the system might reconsider, given that the banks are actually being prudent with taxpayer cash. Now that banks have been backstopped by the Federal Reserve and Treasury Department, they have less incentive to scrutinize credit. The risk of bad loans has been shouldered by Washington. Banks have made a lot of missteps in the financial crisis -- from overreaching with credit to big paydays, to misuse of taxpayer cash, to punitive interest costs for consumers, to a lack of sensitivity -- but reining in credit is not one of them.

So, when Lewis and his counterparts at competing banks brag about how much lending they're doing, take it with a grain of salt. In most cases, this is posturing by CEOs looking to fend off criticism they're not doing enough to help the economy.What critics fail to acknowledge is that we all benefit from banks adhering to lending standards. When that doesn't happen we get financial collapses that compare to the darkest times in our history.