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

The Federal Reserve has run out of ways to stimulate the economy but, according to the author, there is still a way Bernanke can fix the economy. He argues that the Fed's "bazooka" is to break up all the banks and therefore have no shared liabilities and will be fully responsible for their actions.

David Trainer
August 23, 2011
New Constructs

No 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. Jump­start 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: 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 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 $1mm 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.

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