Aid Fueled Latest Surge on Wall Street

Much of the banking system was insolvent last year. Their liabilities were bigger than their assets (capital). There were several potential solutions.
1. Bankruptcy in which the banks do not fully pay back what they owe. The problem is that when big banks do this, the entire financial system would freeze up which was already starting to happen. This is why some banks are "too big to fail."
2. Give the banks money. This was Paulson's original plan. He wanted to buy the "toxic assets" for more than they were worth. None of the TARP money actually bought any toxic (or "troubled") assets even though the first two letters of the acronym stand for "troubled asset".
3. Loan the banks money at low interest rates and guarantee the bank debt. This was what the Paulson Plan did. The idea is for the banks to be able to keep making profitable loans at higher interest rates and thereby make enough profits to restore their capital.
4. Give the banks money by buying their stock. This was decried as socialism and/or nationalism because it would mean that the government would own a majority of some of the sickest banks, but all the other options except #1 were socialist too and this option has the advantage that the taxpayers could get their money back (when stock values are restored with the health of the banks) rather than the bank owners and managers getting much of the profits of the bailout as is now happening.

Because we went with option #3, the banks are now making big profits which was what the TARP plan hoped would happen. Unfortunately, the banks are not loaning much money to small businesses who are the main drivers of employment growth at the end of recessions. The big banks are finding it more profitable to use their low-interest government-subsidized money to make risky bets on the financial markets instead and why not? What do they have to lose?

NYTimes.com:

Many of the steps that policy makers took last year to stabilize the financial system — reducing interest rates to near zero, bolstering big banks with taxpayer money, guaranteeing billions of dollars of financial institutions’ debts — helped set the stage for this new era of Wall Street wealth.

Titans like Goldman Sachs and JPMorgan Chase are making fortunes in hot areas like trading stocks and bonds, rather than in the ho-hum business of lending people money. They also are profiting by taking risks that weaker rivals are unable or unwilling to shoulder — a benefit of less competition after the failure of some investment firms last year.

So even as big banks fight efforts in Congress to subject their industry to greater regulation — and to impose some restrictions on executive pay — Wall Street has Washington to thank in part for its latest bonanza.

...

A year after the crisis struck, many of the industry’s behemoths — those institutions deemed too big to fail — are, in fact, getting bigger, not smaller. For many of them, it is business as usual. Over the last decade the financial sector was the fastest-growing part of the economy, with two-thirds of growth in gross domestic product attributable to incomes of workers in finance.

Now, the industry has new tools at its disposal, courtesy of the government.

With interest rates so low, banks can borrow money cheaply and put those funds to work in lucrative ways, whether using the money to make loans to companies at higher rates, or to speculate in the markets. Fixed-income trading — an area that includes bonds and currencies — has been particularly profitable.

“Robust trading results led the way,” said Howard Chen, a banking analyst at Credit Suisse, describing the latest profits.
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A big reason for Goldman Sachs’s blowout profits this year has been the willingness of its traders to take big risks — they have put more money on the line while other banks that suffered last year have reined in such moves. Executives say there are big strategic gaps opening up between banks on Wall Street that are taking on more risks, and those that are treading a safer path.

Banks that have waded back into the markets have been able to exploit large gaps in the prices of various investments, a feature of the postcrisis financial markets. The so-called bid-ask spreads — the difference between the price at which banks are willing to buy things like bonds, and the price at which they are willing to sell — are roughly twice what they were two years ago.