The Real Reason Banks Aren't Lending

President Obama recently admonished banks "to explore every responsible way to increase lending." That's an admirable goal. Unfortunately, there's reason to believe that the banks are already lending about as much as they responsibly can.

For one thing, there's an interesting "carry trade" going on right now that only banks can access. The Federal Reserve set the Federal Funds Rate at around 0%, giving banks an opportunity to borrow at essentially no cost. But 10-year Treasury yields -- the typical proxies for mortgages -- are around 3.8%. As a result, banks can earn an essentially risk-free 3.8% borrowing from the Fed system and lending to the Treasury, rather than lending to risky borrowers like you and me.

That's easy money if you're a bank. With the Federal deficit ballooning, the Treasury is certainly offering the banks plenty of opportunity to buy government bonds, rather than take a risk on traditional lending.

Theft by government fiat
And speaking of risk, several other government policies are dramatically adding to lenders' risk. Some of these policies have been enacted at the Federal level, and others by states, but taken together, they scare the banks and other lenders away from opening their wallets.

After all, when the government on one hand says "Lend!", but on the other hand says, "You don't really have the collateral you thought you had," something has to give. Unfortunately, that something is most often banks' willingness to lend to anyone other than the most creditworthy.

In essence, these policies have diminished the property rights of lenders. In effect, they turn every loan otherwise secured by a change of ownership in bankruptcy into the equivalent of an unsecured credit card. When banks and bondholders lose their ownership rights in bankruptcy proceedings, they lose much of their incentive to loan to anybody that needs the money. That doesn't make lending impossible, but it certainly makes it tougher and costlier.

Hitting banks particularly hard is the concept of mandatory mortgage modification. Such enforced after-the-fact contract changes make it perfectly clear to lenders that they don't have the same rights to foreclose they thought they had when they made the loan. Bank of America (NYSE:BAC), for instance, had to set aside $8.4 billion in a mortgage modification settlement with various states.

Without a credible threat of foreclosure, banks have no protection against speculators leveraging up with the banks' money if those speculators can simply demand a sweetheart deal when their gambles don't work out.

Other lenders have been hit hard by bad government policy as well. Some of the more pernicious examples include strong-arming bondholders into accepting deals whereby …

• Chrysler was handed over to its unions, Fiat, and the U.S. and Canadian governments, while its bondholders were given a few dimes on the dollar.
• General Motors was also handed over largely to its unions and the U.S. and Canadian governments, with its bondholders getting only about a 10th of the company.

It used to be the case that bondholders were in a stronger position in bankruptcy negotiations. They could, for instance, reject bankruptcy settlements, and under the concept of absolute priority, would receive their share of liquidation in order of the seniority of their claims. Interest rates and lending levels were set with absolute priority in mind, but with that concept disrupted by government policy, a key foundation of the debt market was heavily damaged.

In fact, every time Uncle Sam dictates that lenders have to adjust the terms of their loans, or that bondholders do not deserve their seat at the table when an indebted company files bankruptcy, it threatens to weaken the debt market further. As President Obama's feckless plea to banks to lend more money underscores, no amount of jawboning will really get banks to widely open their lending spigots again.

Not all borrowers have been cut off
That said, there is a class of borrowers who can still borrow money. In general, borrowers who don't actually need loans, but who choose to take out loans to help fund things like their expansion plans, can still access the debt market. And that ability to access capital can provide them a tremendous competitive advantage over their less-well-financed competitors.

After all, if a company can borrow, it can deploy that cash much more quickly in expansion opportunities than one that needs to save up cash from operations to fund its investments. Those most likely to be financially healthy enough to continue to borrow are ones with these characteristics:

• Have debt-to-equity ratios below 100%. A ratio in that range indicates that the company has not gorged itself on debt in the past, making it therefore much more likely to be responsible with its borrowings in the future.
• Keep more cash and equivalents than current liabilities on their balance sheets. Doing so means the company is in a very strong position to pay back what it owes and has coming due in the near future. That keeps potential lenders extremely happy, because it helps protect their investments.
• Have positive tangible book values. Unlike total equity, tangible equity only includes physical assets that may be worth something in a liquidation sale. Lenders concerned about the return of their capital will be much more willing to loan to companies with tangible equity than those whose balance sheets are loaded with goodwill and other intangibles.

When you find companies that fit that profile, you tend to see ones like these:

Data from Capital IQ, a division of Standard & Poor's.

How these companies give you an edge
Their strong balance sheets give them the opportunity to access the capital market, even in these tight times. That allows them to invest more in their futures, and actually think about growth, at a time when many of their competitors are constrained and forced to shore up their own balance sheets. As an investor, owning that sort of strength in a time of overall economic weakness positions you to profit as the overall economy recovers and their growth materializes.

At Motley Fool Inside Value, we love owning strong companies in a time of weakness. If you understand how balance sheet strength today can lead to improved profits in the future, then you've got what it takes to join us in our quest to own the strongest companies around. Your 30-day free trial starts here, and gives you access to our current picks, analysis, and the tools we've amassed to help you find the strong companies that become great investments.