Bloomberg is reporting on what happened during the bailout meeting with the banks in Paulson Lacks Leverage to Compel Banks to Put New Cash to Work

Treasury officials acknowledge they can’t force banks to get the taxpayer money into the hands of their customers. Instead, officials are betting that the government’s investment will create conditions where banks have a greater incentive to earn profits from lending than to hoard money to shore up their balance sheets.

“It’s in their economic interest,” said David Nason, the Treasury’s assistant secretary for financial institutions, in an interview with Bloomberg Television. “When you give them a stronger capital position and you also provide a certain amount of government backstop to their funding sources, it’s incumbent upon them to go out and continue to lend.”

Allow me to translate: The government has forced banks to accept cash, required that the banks pay 5% on that cash, then up that to 9% after 5 years. There’s also a 15% warrant issue, but that actually has very little impact on this game. The point is to force banks to lend. Note that this is after slashing interest rates.

How can a bank make money on this cash injection? Certainly, it can help cover losses, but at 5%, that’s expensive use of money. The purpose is to get banks to lend. Who wants to borrow right now? If I was a responsible business, and times look tough, I wouldn’t borrow for expansion. It makes no sense to expand in this business environment. Perhaps I would borrow to invest in efficiency improvements. However, if I’m a responsible business, what kind of efficiency gains can I expect from investment right now? Unless there’s a scenario where I get better than 10% efficiency gain, I’m not sure it makes sense to invest in efficiency. So who’s left? If I’m a business in a bad position, I’m going to try to stay afloat by any means necessary. If that means borrowing at bad rates, I’ll still do it. After all, what have I got to lose?

Let’s go back to risk management, and decreasing leverage with increased risk. No, let’s just sum it up with a glib idiom, “Banks are in the business of making loans to people that don’t need the money.” This is good business sense for banks. The alternative is what caused this mess.

This seems to be our government’s approach to the whole crisis. They have to do something, with no regard to whether they are attacking the root problems. If the root problems were reckless lending, how does forcing banks to lend improve the situation?