Fixing Wall Street: It's Time To Break The Axis Of Artifice

by: Charles A. Smith

Several thousand (mostly young) people are currently protesting in Zuccotti Park near Wall Street. One of their messages is that large financial institutions control too great a portion of the nation's wealth, and should therefore be broken up.

Interestingly, Wall Street itself attempted to deliver this same message three years ago in the form of a financial crisis and stock market crash. But instead of allowing market forces to swing the sledgehammer, our political leaders enacted a rescue package which rendered the too-big-to-fail banks even bigger. Sadly, such perverse outcomes have become the norm in the U.S. economy in recent years. This essay summarizes some of them, and in so doing lays out a few of the reasons the economy is moribund. Talk of renewed recession is in the air, and unless our political and financial leaders change course and stop subsidizing zombie banks, our economy is likely to continue to stagnate.

The answer to the question of why the economy can't get off the dime goes as follows: You don't encourage risk-taking and economic activity by driving down returns. Growth happens when investors take risks justified by high prospective returns. Prospective returns are high when asset prices are low. Unfortunately for our economy, nearly every policy enacted since the fall of 2008 has discouraged risk taking by temporarily and artificially inflating asset prices. The best example is the housing market. Fiscal and monetary policymakers have enacted one strategy after another to prop up home prices. Federal tax credits for first-time buyers, payment assistance for delinquent homeowners and large purchases of mortgage-backed securities by the Federal Reserve have all been tried, with little long-term effect. Home prices continue to bleed, and will do so until they reach an equilibrium determined by real supply and real demand, not the artificial demand created by politicians and the Fed. How much lower might they go? Our best guess is that a cumulative decline of as much as another 10% for the average U.S. home over the next three years would bring prices in line with incomes and available mortgage credit.

Another example of policy error is the artifice in mortgage rates themselves. Ninety-five% of mortgages currently underwritten in the U.S. are backed by the Federal government in the guise of Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) or the Federal Housing Authority. Most banks will not write a new mortgage unless they can immediately sell it to the Feds. What do you think this means for mortgage rates? Where would rates be without a ready buyer for 95% of originations? Three percentage points higher? Four? The price of credit in today's housing market would undoubtedly be higher if taxpayers were not providing a backstop. Artificially low mortgage rates keep home prices artificially high, which in turn acts to dampen real demand because buyers aren't sure if prices are authentic. Buyers sit on their hands and try to decide if the subsidy is permanent. This sends prices lower over the long term. Perverse? Yes. Unfortunately, also the norm in today's federally "managed" housing market.

The most egregious illustration of a subsidy designed to inflate asset prices is the Federal Reserve's policy of keeping short-term interest rates at or near zero (ZIRP). Soon after the financial crisis in the fall of 2008, the Fed cut the rate at which it lends overnight money to banks to less than 0.25%. This change acted as a massive subsidy to the banking system, in that it gave the banks nearly unlimited amounts of money to buy longer-term securities and earn a "spread" on the difference between their (nearly free) money and the rate earned on the securities. This policy has the effect of driving retail rates for short term investments (bank CDs and money market funds) to near zero as well, crushing the incomes of many retirees and small savers. Policymakers are effectively picking the pockets of middle America to fund both weak bank balance sheets and government spending. Can you say "Tea Party"?

ZIRP keeps the banks flush, however. This is the true goal of all the policies mentioned above: Keep the prices of failed investments from the last cycle (mortgages, strip malls, housing developments and financial assets in general) high enough long enough so that the banks don't have to admit they're insolvent. This gives them time to earn their way out of the problem by pocketing the spread on government bonds and other low-risk investments. Call it extend and pretend, pray and delay, whatever you want; the goal is the same. What the strategy does not do, however, is encourage risk taking. Zombie banks don't have to make loans when they can rake small savers and the taxpayer for their daily spread. So they don't; as of June 30, 2011, net loans and leases held by all FDIC-insured U.S. banking institutions were 9% below the level of 3 years ago. Credit continues to shrink; the economy flounders.

The Wall Street protesters are onto something. They've figured out that policymakers have colluded with bankers to form an Axis of Artifice. The Fed and the administration pump cheap money into the system to keep asset prices up; bankers funnel much of it right back into government spending and debt. Each takes its cut along the way. Meanwhile private credit stagnates, small business withers and unemployment soars. The winners are those closest to the great money flow between New York City and Washington, DC. The rest of us go down the tubes. There's a solution to this dilemma, however; one I believe would be quite amenable to the ragtag group in Zuccotti Park. We need to break the axis by electing new leaders who will stop the artifice and let rich people fail.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.


This article is part of a series of articles on Seeking Alpha on Fixing Wall Street - a response to the Occupy Wall Street protests. Other articles include: