The Fed’s Bazooka: Revealed As Final Policy Firepower in Jackson Hole

david trainerNo more Mr. Nice Guy. It is time for Mr. Bernanke to break out the big guns in Jackson Hole this Friday.

Though the Federal Reserve Chairman has run out of ammunition for stimulating the economy, he can still take action to fix the economy.

I named the action Mr. Bernanke should take the “Fed’s Bazooka” because it is, in terms of market impact, comparable to former Treasury Secretary Hank Paulson’s bazooka.

The time has come to move beyond the flaccid short-term stabs at stimulating the economy and show the strong, decisive leadership needed to restore confidence in the capital markets.

Let’s face facts. The bailout strategies, despite costing taxpayers $1.6 trillion, have not worked because they rely on “the same financial companies that got us into this mess.[1]

The “Fed’s Bazooka” is the option to break up all the banks that are “too big to fail." Breaking up means separating the deposit-taking and lending arm of the bank from all trading, investment banking and other speculative activities in which broker-dealers engage. The separate banking units would stand on their own with no shared liabilities. The high-risk-taking activities of one entity only affect that one entity. They take full responsibility for their actions. If they over-spend or lose too much money on bad bets, then they go bankrupt just like every other American corporate entity.

In addition, the high-risk-taking entities would remain under Fed supervision and would be subject to the same capital requirements and leverage restrictions as those applied to traditional banks. Importantly, derivatives would be regulated and cleared through a central exchange to ensure that banks do not become too-interconnected-to-fail or take on greater liability than they can afford.

It is within the Fed’s power to break up the banks. In exchange for taking bailout funds in 2008, all of the big banks had to submit themselves to the supervision of the Fed.

Mr. Bernanke should fire his bazooka this Friday because it would:

  1. Jump-start lending by freeing up capital that is otherwise put at undue risk
  2. Restore confidence in our banking system and government leadership

Allow me to explain.

Repealing Glass-Steagall is one of the biggest mistakes ever made. As long as banks are allowed to fund the high risk/return investments with consumer deposits (super cheap capital), they will continue to do so. If you were faced with a choice between high-profit trading and investment banking investments or loans to sleepy ole' main street America, which would you choose? The money goes to the highest return opportunity every time.

On top of the superior return opportunity, throw in the fact that the too-big-to-fail-banks may actually only be accountable for little to none of the risk of their high-risk trading and investment banking activities.

Why not roll the dice and take bigger and bigger bets if you can enjoy the tremendous upside potential without having to be accountable to the downside risk?

The point is that as long as Bank of America (BAC – dangerous rating), Citigroup (C — very dangerous rating), JP Morgan Chase (JPM – dangerous rating) and any other banks that have trading and investment are banking under the same roof as consumer and small business lending, we cannot expect lending to consumers and small business to grow much. The capital is not available because either these banks have higher-profit uses for it, or they are afraid they may need it to cushion losses in case some of the bad risks they have taken come home to roost.

None of the banks want to have another bailout, but as long as they are too-big-to-fail, they know, given the fragile status of the global financial system, that the federal government has no choice but to bail them out. Explicitly or implicitly, the bailout guarantee is there.

Therefore, as long as there is risk that the Fed could again authorize taxpayer money to provide a safety net for the risks taken by the too-big-to-fail banks, investors of all types will have a tough time having much confidence in our financial system as well as our long-term economic health.

Misappropriating taxpayer funds to pay for the losses of Wall Street fats cats not only throws good money after bad, but also it stinks of downright corruption.

And I mean it when I write “misappropriation” as Wall Street exploited the fact that bailout funds were extended without any restriction on how they were used for compensation. Here are the numbers on how Wall Street got rich off taxpayer money. In 2008 when Congress launched the $700 billion Targeted Asset Relief Plan (TARP) to save the cash hemorrhaging banks, Wall Street paid out $18 billion in cash bonuses[2]. Total Wall Street compensation rose to an all-time high of $135 billion[3] in 2010, a 6% increase from $128 billion in 2009. Total bailout funds extended through the entire crisis were $12.8 trillion[4].

Income redistribution to people in genuine need is understandable. Income redistribution to the rich culprits who caused the financial meltdown is difficult to accept.

How can the Fed, Congress or the White House expect to have any credibility with the American public after swindling us like that?

What’s worse is that the swindling has been going on for some time. The recent bait and switch of risk for cash is, in my opinion, the natural progression of a very bad trend. That trend is the increasing amount of influence that Wall Street has on Washington. That influence translates into laws and regulations that enable Wall Street to enlarge their treasure chests of profits, which, in turn, buy more influence.

How much influence? …As much as money can buy. In his April 4, 2010 interview with ABC, Larry Summers points out the fact that the financial services sector (i.e. Wall Street) spent, in 2009, about $1m per congressman while employing four lobbyists per congressman. That is a lot of money and it buys a lot of influence. I am speaking from experience when I say that dissenting voices have a very hard time competing with the enormous Wall Street lobbying power. And when lobbyists cannot get the job done, Wall Street brings in more firepower. Click here for details of a prime example: Alan Greenspan and Larry Summers crushed Brooksley Born’s (former head of the Commodities Futures Trading Commission) proposal to regulate credit default swaps in the late 1990s[5].

This influence empowers Wall Street to bend regulations and laws to their money-making favor. This kind of swindling is sometimes subtle, and it is sometimes obvious: e.g. the Global Research Settlement for allowing research analysts to get paid for IPOs on which they were supposed to be providing objective advice. I could write a great deal more on the subject of Wall Street’s self-serving manipulation of financial statements and research. For now, I refer you to my article on Citigroup[6] (C – very dangerous rating) and article on Morgan Stanley[7] (MS – dangerous rating) for more details.

The bottom line: I don’t believe there are any words that can restore investor confidence. Only decisive action will do.

The bigger the Wall Street monster gets the more destructive and exploitative it will be and the consequences could be devastating.

A capitalistic system only works when markets are truly free. When any one participant in a market can influence the rule makers and get rules and laws written in their favor, they can corner the market. Then the market is no longer a free market.

I believe Wall Street has already cornered many markets, albeit in a subtle enough way as to not arouse too much suspicion…at least not from the general public. Keeping market manipulation subtle keeps awareness, and, therefore, resistance low.

The time has come to pull our heads out of the sand. It is time to stop giving the culprits responsible for much of our predicament hard-earned taxpayer dollars.

That giant sucking sound we hear as the stock market tumbles will continue. That sucking sound is the depletion of the trust and social capital critical to the proper function of our capital markets.

Until investors trust they will not get robbed, confidence will be hard to come by.

Without confidence and trust in the financial system, everything grinds to a halt.

Mr. Bernanke, the time to act is now. The longer we delay, the worse the problem gets as the more capital gets wasted and the lower the stock market goes.

Disclosure: Citigroup © is on New Constructs’ Most Dangerous Stocks list for August. I receive no compensation to write about any specific stock, sector or theme.

[1] http://www.prwatch.org/news/2011/08/10924/money-still-owed-federal-bailo...[2] “On Street, Pay Vaults to Record Altitude”, Wall Street Journal, February 2, 2011

[3] “Executive Pay”, New York Times, March 3, 2011

[4] “The True Cost of the Bank Bailout”, Public Broadcasting Service (PBS), September 3, 2010

[5] “The Warning”, Frontline on the Public Broadcasting Service, October 20, 2009

[6] Here is link to my Citigroup article: http://blog.newconstructs.com/2011/05/17/sell-citigroup-before-the-earni...

[7] Here is link to my Morgan Stanley article: http://blog.newconstructs.com/2011/05/03/sell-morgan-stanley-before-it-s...

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