I was reading this article today on CNN.com about today’s meeting between President Obama and the CEOs of a dozen major banks. His displeasure with the banking community was shown in yesterday’s interview on 60 Minutes, when he said that he did not come to Washington to help out “fatcat” bankers. I’m sure that’s just the kind of thing these guys want to hear before their meeting. (Note to Obama: if you are going to ask someone for a favor on Monday, try not to publicly insult them on Sunday.)

The article brings up several great points. The federal government bailed out many of these banks through the TARP program when they suddenly found themselves with housing assets that weren’t worth nearly as much as they thought they were worth a year before. So to remain solvent, they borrowed the cash from the government. The government did not put many strings on what the banks could do with the money — and some of them responded by buying up other banks. The federal government even forced its way into a few banks, telling their CEOs that if they did not take some of the money they would be audited.

[If you wonder why I'm skeptical of federal government power, this is a prime example. What lessons do we learn from TARP? If you give people money without conditions, they'll take it and do things they think are most appropriate. If you put conditions on the money, they may not want to take it. Only the federal government thinks that their goal should be to design a way to force banks to take money with conditions on it so that they then have control over them and can make private companies do the government's bidding. Hmm...I wonder if that will happen with health care.]

I remember when President Bush and Congress were trying to justify passing TARP. They knew that a Wall Street bailout would be unpopular, so they told us that the world would basically collapse if we did not pass it, and they also told us to look on the bright side: if this works like other bailouts (Chrysler, for example), we’ll get all the money back with interest and John Q. Taxpayer could even make some money on the deal. Cha-ching! I mean, how can you not pass such an obvious money-maker for the people, right?

As it turns out, that seems to be exactly what’s happening. The banks have already paid back $71b of the $205b that was loaned out, plus another $7b in dividends. That’s supposed to be good news, right? Now taxpayers aren’t on the hook for these toxic assets any more. But it doesn’t seem like that’s what the people in charge of our financial institutions want. Obama and Geithner are not happy about this. They don’t want the banks to pay the money back because, once they do, the government no longer has any control over them. Although that may change if Congress passes the House’s Banking Reform Act — then they can decide that any private insitutition they deem too dangerous to fail can be taken over by the government. Yay for government! But until it passes (and it will, since any bill increasing Congressional power seems to pass pretty easily), Obama has very little power today to force these bankers to do anything. He wants them to start making more loans to small businesses, but the banks don’t want to loan the money. We know credit is tight these days, but has anybody stopped to ask why banks are not making these loans? After all, if loans were profitable, banks would make them and earn profits on them. So why aren’t banks making small business loans? Because these loans right now are not a great risk for the banks. (Remember when banks were the bad guys for taking on too much risk? It seems so long ago…) Back in February, the Small Business Administration’s (SBA) default rate on its loans soared to 12%. If it were your money on the line, would you make a loan if there were a 12% chance that you would lose the principle and get absolutely nothing in return? Didn’t think so. The last time we tried to get banks to make loans to people who had a high risk of default, it was called the Community Reinvestment Act and it helped lead to the subprime mortgage crisis that caused the current recession (or is it former recession? I’m not sure – if you ask Christina Romer and Larry Summers, whose offices are adjacent to each other in the West Wing, they’ll give you two completely different answers.)

(Update: This article explains that a study of business bankruptcies found that 50% of them were current with their lenders when they suddenly declared bankruptcy — the lenders never saw it coming. Yet another reason why lenders might be reluctant to loan to small businesses in today’s economic climate.)

As proof that the banks are not lending enough, you can look at statistics showing that the amount of lending has fallen. But we also know that individuals have become more conservative with their finances and do not want to borrow as much. The current saving rate is the highest it’s been in decades — a great sign that people are finally being financially responsible after so much excessive consumption. Obama says credit supply has fallen; bankers say credit demand has fallen. And as all my students in principles of microeconomics should know: if all you know is that the quantity of a good is down, you cannot determine whether demand or supply fell (or both) without knowing what happened to the price. Unfortunately, price data is difficult to come by. I spent a good deal of time searching for small business loan interest rates this morning and could find no historical data — let me know if you find any. For now, let’s just say that both are possible explanations. But even if supply has fallen, there is a perfectly rational explanation for it: small business loans in today’s climate are extremely risky.

Sure, it’s easy to put the blame on the “fatcat” bankers — everyone in Washington loves to do that. Politicians would have you believe that large salaries and bonuses for CEOs and bankers is the source of all problems, but they’re insignificant in the relation to the entire economy. All a bunch of sound and fury signifying nothing. But let’s deal with the facts. If I discovered that a company I owned stock in were loaning money out and getting none of it back 12% of the time, I would sell my stock in that company.

If you want banks to make more loans to small businesses, you need to bring some certainty back into the economy. Small businesses don’t know what will happen with cap and trade regulation and they don’t know how much a worker will cost them if health care reform passes — so they’re sitting on their hands while unemployment passes 10%. There are plenty of good workers out there to be hired, and firms would love to hire them, but without knowing the long-term cost of those workers, it’s not worth the risk. If you want the unemployment rate to fall, reduce small business income taxes and capital gains taxes, make it clear how much health care will cost or abandon the effort, and reduce business regulations. Then you’ll see small businesses succeed and banks extending more credit.

Or you can just blame the bankers.