We heard Robert Albertson, Chief Strategist at Sandler O’Neill, make this comment to CNBC’s Maria Bartiromo in December 2009. We were struck by the simplicity of the statement at that time. We were reminded of it as we heard President Obama announce his plan of imposing a tax on America’s largest Banks for profiteering and for obscene bonuses.
This is not a political article, only an attempt to understand the real problem that confronts the American economy.
Professor Robert Shiller of Yale began warning about the housing bubble a couple of years before it burst. He is a sound. honest and nonpolitical economist. He has made the case on several occasions that America’s prosperity during the past couple of decades can be attributed to the financial innovations created in the American Financial System. In fact, Shiller has argued that one of the reasons for the lack of economic progress in other countries is the lack of flexibility and structural rigidity of their financial systems.
Larry Fink, the CEO of BlackRock, is one of America’s foremost financial thinkers and practitioners. His firm avoided the mistakes of many others and today is the world’s largest asset manager. Those who listened and followed Mr. Fink’s comments in October 2007 protected themselves from the crushing bear market of 2008.
About a year ago, Larry Fink began speaking about the risks to the resumption of growth in the American economy. The biggest risk he saw was that the American Financial System had become too small to finance the future growth of the American economy. The quote from Robert Albertson is another way of saying the same thing.
Americans in all walks of life understand that the American Financial system is still broken. Small Businesses, Entrepreneurs and hard working Americans are still being cut off from the flow of credit. Any credit they get is very expensive and laden with conditions. At the same time, they see large banks manufacturing record profits from what seems like thin air. They simply do not understand this dichotomy and they are livid.
Most Americans do not understand the reality that Large Banks are NOT the American Financial System. Banks are a part of the System, a vitally important part, a part without which the entire system would fail and nearly did in 2008. But repairing the Banks is not the same as repairing the American Financial System.
The American Financial system began evolving and innovating in the 1970s. During the past 3 decades, a vast secondary system was created to funnel liquidity from the Banks & the Federal Reserve to the private market. This secondary market came to be known in simple terms as Securitization.
As the secondary market or securitization grew, the share of banks in lending to the American economy shrunk. As Chairman Greenspan reduced interest rates from 2000 to 2003, Securitization grew in importance. As Greenspan kept interest rates artificially low from 2004-2007, the growth of money supply reached bubble proportions. As a result, the securitization wave reached its zenith in 2007.
Then the volume of securitization went into a waterfall decline in 2008-2009. As a result, the American Secondary Market System virtually shut down. It continues to be so today. That is why the private American economy is suffering from a debilitating credit squeeze.
We like to think simply. So we think of the American Capital Markets (Treasuries, corporate bond market, stock market etc.) as the engine of the American Financial System. This engine, with help from the Federal Reserve, creates the power of liquidity for the American economy. We think of the American Secondary Markets as the Transmission of the American Financial system.
The story of 2009 is that the engine of the American Financial System is roaring again at full power. But the Transmission is broken, almost dead. As any car owner knows, without a working transmission, pushing on the accelerator does nothing. The wheels don’t move.
To put in another way, the American Federal Reserve did its job but the US Political System did not do its job. The success of the Fed can be seen in the phenomenal rally in all public markets, the stock market, the corporate bond market, the high yield market, literally any credit product that trades on public markets. But the private credit market remains broken and virtually dead. A great example of this is the Commercial Real Estate market. This sector is still struggling and the loans to commercial estate projects are still underwater. But the commercial Reits (Real Estate Investment Trusts) are healthy because they were able to raise massive amounts of cash from the public financial markets.
This sounds like rampant speculation to the American people and in a sense it is. But it is a rebuilding phenomenon. It is a sign that the engine of the American Financial System has been fully repaired.
The critical need of the day is to build a new transmission mechanism for the American Financial System. This task requires the best financial, business and political minds in America to come together with a sense of mission.
Unfortunately all we see and hear is insane rage from America’s politicians and media. This week we saw President Obama vilifying America’s Banks and imposing additional taxes on the largest American banks. We saw Congressional leaders engage in public trials of Fed and Treasury Officials for their efforts during the most terrifying 2 weeks in recent American financial history.
Our simple question is how does all this help rebuild the transmission of America’s Financial System? It does not and it will not until we face the next big risk.
And that risk may be just ahead of us. The Federal Reserve has pressed its foot on the accelerator of liquidity for so long that the engine of American Capital Markets may be overheating. The Fed will be forced to take its foot of the accelerator sometime this year. When it does, the engine of American Capital Markets will slow down or shut down for awhile. Then the American Financial System might find itself without either an engine or a transmission.
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