Why are banks cancelling the good loans?

I've heard a few personal tales of perfectly good borrowers with perfectly good leased-up commercial properties finding that their formerly perfectly cooperative bank is declining to renew a mortgage. It seems strange that banks would decline to make safe and profitable loans during a time when they must be desperate for safe and profitable loans. But, we need to imagine ourselves in the mind of that banker...

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Sure, my bank has fifty billion of assets that we have no clue how to value, or how secure they are. They're just sitting there and we're going to have to figure that one out with Paulson and Bernanke. But, I do have this other twenty billion over here and I most definitely understand the quality of this batch. These are good loans to good borrowers, but the accounting rules require me to carry them at 70 cents on the dollar, since that's what they're trading for on the open market. Heck, I'll make at least a 40 percent return on these assets if I simply hold them to maturity.

But -- the regulators are going to make me sell them if I can't raise some capital or reduce my total loan portfolio! What am I going to do? My kids need new shoes and I need new golf clubs. Hmmm...the capital we raised came from the Feds and is tied up supporting that fifty billion in assets that we (and they) don't understand. I'll need to reduce my total assets in some way...hey, here's a loan that's coming due for one of my longtime clients. I can only get away with charging this guy 7 or 8 percent, but he's a good borrower with a great property.

What to do? I can make 40 percent by keeping these oddball assets that the regulators don't like, or I can make 7 percent by renewing that commercial loan to my longtime client and golfing buddy.
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We see where this is going, don't we? Banks are being perfectly rational by calling in low-risk loans because they are also low-yielding loans. There is more money to be made investing in oddball assets that are also low-risk.

This is pretty much the same thing we're doing by not buying Treasury bonds or California GO bonds -- they're safe, but they don't yield diddly. We can make more money by buying very high-quality bonds that the market simply happens to hate at the moment -- GNMAs and local goverment revenue bonds among them. Capitalism is not a perfect system -- its flaws run deep and are well understood. But in this instance, the market forces that push us toward the best combinations of risk and return will serve their purpose in the fullness of time.