The Biggest Cost of the Bailout

 |  Includes: DIA, EZU, IEV, KBE, KRE, QQQ, SPY, XLF
by: Envelope Investing

As the market continues to go up day after day, it is fairly easy to forget about the banking crisis. It seems like a thing of the past. The reality is that the bailout of the banks continues and this may be the most expensive part of the bailout to date. To be fair, it isn’t as much a cost as it is a theft; a sort of Robin Hood in reverse. By keeping the Federal Funds rate at ¼%, Bernanke & Co. are stealing money from the common man and giving it to the banks.

The Fed has created a situation where responsible individuals are being paid a negative real interest rate on their banking deposits. With every day that goes by, conservative Americans with some money in the bank are getting poorer. Their wealth in real terms is dropping at faster than 2% per year and that negative return is getting worse as inflation starts to accelerate.

This is not only punishing responsible Americans, but also it is creating a huge moral hazard where conservative investors are forced to take on more risk than they would ordinarily be comfortable with just to try to stop from going backwards. The Fed tries to justify this monetary policy by saying that they are getting the banking system going and in the process creating lending which will benefit all consumers.

The unfortunate reality is that most of the artificially cheap money that is being rained down upon the banks has been used to buy up 1-2 year Treasury notes, thus creating a massive carry trade. The Fed has helped to transform banks and brokerage firms into highly levered short-term bond hedge funds. This carry trade benefits nobody but banks and brokerage firms. Their trading profits are going though the roof and bonuses are flowing to senior execs once again (in many cases, the same execs that we had to rescue not so long ago), and of course their capital ratios are improving.

The real problem here is that there is no value being created by the Fed and the banking system. It is just taking money from responsible Americans and giving it to the banks.

Bernanke & Co. need to stop this crooked monetary policy at once and start raising rates. Stop this hidden bailout; this theft from the American savers; this moral hazard. Moving the Fed Funds back toward a 2-3% would not cripple the economy. Quite the opposite; it would wean banks off of the carry trade and force them to make money the old-fashioned banking way: by lending it out. If banks cannot survive without being given stolen money at this stage then they should be allowed to fail. There should be no more free lunch.

Of course, the Fed will not raise rates soon enough, as they won't bite the hand that feeds them, but I think within the next several month there is a going to be a big tsunami that is going to increase shorter term yields all around the world. The Greek bond crisis is certain to spread to Portugal, Spain, Italy, and Ireland. We will learn the lesson again that we learned during the collapse of long term capital; that sometimes assets are more correlated than one would think. Government bond yields will go up dramatically around the world. This is going to cause the carry trade to come unwound.

There is no such thing as a risk free trade, even if somebody is giving you free money; especially when the trade is as crowded as the current Fed induced carry trade.

Disclosure: No position