The Treasury Yield Curve Makes TARP Obsolete

Larry Kudlow wrote a very good explanation on why the current recovery of the banks is not due to TARP, but to the upward-sloping Treasury yield curve.

When the Fed loosens money, and short-term rates are pulled well below long rates, banks profit enormously from the upward-sloping yield curve. This is principally because banks borrow short in order to lend long. If bankers can buy money for near zero cost, and loan it for 2, 3, or 4 percent, they’re in fat city. So the upward-sloped yield curve is the real bailout for the banking system.

Now, turn the clock back to 2006 and 2007. In those days the Treasury curve was upside down. Due to the Federal Reserve’s extremely tight credit policies, short-term rates moved well above long-term rates for an extended period, and that played a major role in producing the credit crunch. Since interest margins turned negative, the banks had to turn off the credit spigot, and all those exotic securities — like mortgage-backed bonds and various credit derivatives — could no longer be financed.

The truth is that the tightening of the money supply during periods of economic expansion will always lead to to a downward yield curve, but this is part of the economic cycles. The tightening is required to prevent inflation that would normally accompany a huge growth. It's what brings us recessions every 8-10 years. Now, it has coupled with a few other events, like the real estate bubble and the introduction of all those exotic investments, to hit banks harder than normal. But once the Fed loosened the money supply, the yield curve is turning upward, and this is what will help banks recover.

Of course "downward sloping Treasury yield curve" doesn't have the same impact as "predatory lenders", "evil CEOs", or "failed Bush administration", so politicians and media pundits will keep hammering the latter.