Important Note: The Federal Reserve (Fed) is not the Federal government (feds). The Fed is independent of the Federal government, and its actions may or may not align with the elected ruling establishment.
The $64 question to determine where the economy and markets are heading depends on the relationship between the Federal government and the financial industry. If the financials and feds are in harmony, then we will recover; if not, then it's every man for himself.
A special relationship between the financial industry and the Federal government was formed with the creation of the Federal Reserve in 1913, and over the years a perverted mutual dependency has grown. Specifically, while the Fed is elected by and accountable to the bankers, the Federal government is elected by and accountable to the populace (in theory at least). Ideally, the bankers should be controlled and regulated by the Federal government, but in practice, the industry is self-regulated by a myriad of agencies and associations, the Fed being the most notable.
The ability to create (or destroy) money gives the Fed more power than the feds. The natural cyclical movements of the economy are magnified with each expansion or contraction of money in circulation. While policymakers get much of the credit (or blame), the truth is the Fed wields enormous power behind the scenes. Over the years the relationship has evolved into "don't ask, don't tell", where the politicians abrogate their authority in return for support from the banking community. The bankers provide support for re-elections, future job opportunities, or improved career paths. If you ever wonder where politicians go when they leave office, look at how many migrate to 'consultant, advisor, and lobbyist' in the banking/insurance industry.
When the system breaks down, the hunt for responsibility ensues. As the system has devolved into a sham, everyone attached must find blame. Scapegoats are searched for, and heads must roll, because the truth can NEVER be that the system needs an overhaul. The tough part is gleaning through the information to figure out who is "in" and who is "out". Disinformation is rampant, and misdirection is a standard MO. We must never forget the difference between being tough and appearing tough, and that subtlety can not be understated.
Beginning with the exit of Bush and the entrance of Obama, the landscape of blame has reached a new level. Not only was the crisis the deepest in many decades, but the actions taken by both political parties unprecedented. Finding protection from fault has stretched the traditional playbook's fabric very very thin. Behind the scenes, the bailouts and recapitalizations continue, but on the surface it appears that a rift has developed between the feds and the Fed, at least when it comes to the banking sector. Or is this just another sleight of hand magician's trick?
Feds Take Strong Action
Last week's suit by Federal Housing Finance Agency (FHFA), on the surface, takes the cake for the most absurd and damaging example of litigation gone wild. To sue 17 of the largest financial institutions three years after the fact on the basis that the two largest government owned buyers of mortgage backed securities were 'duped' is completely insane.
Bank of America (NYSE:BAC) has been rumored to be Lehmanized for roughly a month, and the only reason the rumor has ears is the fear that its legal liability will exceed its $125B in net tangible book value. When the government shows no leadership, but instead joins the feeding frenzy, the cannibalistic consequences could very easily topple our whole economic system.
BAC might be the biggest and most infamous, however, there are plenty of other names being sued that put our system at risk if this legalfest continues. JP Morgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), and Citigroup (NYSE:C) all have substantial exposure. And, as the US feds carelessly destabilize our own financial infrastructure, why not throw in Deutsche Bank (NYSE:DB), Credit Suisse (NYSE:CS), and Royal Bank of Scotland (NYSE:RBS) too! (Like Europe needs another reason to come unglued.)
Are the feds serious - will they really attempt to extract several hundred billion dollars out of the system, and in the process, bring down some very large players?
Or Is Help On The Way?
The other possible scenario regarding the tough stance by the feds is that they are actually attempting to preempt the avalanche of outside legal liability threatening the sector. By inserting themselves into the equation, the FHFA is now in a position to meaningfully negotiate a settlement, which could in theory be more favorable to the industry as a whole. So while they appear to be tough on bankers, in reality, they may be a white knight.
The Truth Determines Our Path
While many speculate on the motives and eventual outcome, the recent turmoil caused by FHFA is no doubt unsettling. If time shows that the feds are crossing swords with the Fed (and by extension the large banks), then the war that ensues will be like none seen for over 70 years. The mega banks control large swaths of money creation, through traditional banking, investment banking, and mergers and acquisitions. Their establishment ally, the Fed, can make life miserable for all, and monetarily shrink us into depression.
On the other hand, if the FHFA is simply playing a role in the traditional drama of politics, then the rift isn't real and the sideshow is temporary. The appearance of toughness for political purposes can be purposeful, but the lack of teeth will continue to maintain the status quo. In the absence of outright war between our elected leaders and the entrenched banking class, the can will indeed be kicked down the proverbial road.
Action To Take: Be Cautious
At this stage it is too early to tell whether a new dynamic has been introduced into the mixture between the Feds and the financials. While we are aware on the surface that the FHFA suit is very negative, we also believe the actions taken to date by this administration have been protective of the banks overall. We believe caution is prudent from both sides of the market at this time, because in the relationship between the feds and the financials, it's too early to determine if they are new enemies or old allies.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.