The Elephant Wall Street and the Fed Doesn’t Want You to See

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

“Banks have conditioned us to trust them and what have we got from that?” – Mark Baum (Steve Carell)- The Big Short

In his book and movie, The Big Short, Michael Lewis tells the story of a few intelligent and courageous investors who saw what no one else wanted to see. Instead of turning a blind eye to absurdity, they did their homework. What they quickly found was many subprime loans were likely to default. These investors were laughed at by Wall Street’s “best and brightest” simply for betting on an obvious truth.

Myopia and fat profits clouded the ability of many investment professionals to see the housing bubble. Worse, well-educated PhDs at the Fed, charged with preventing financial instability, had the same blind spot.

Now, a decade later, a much larger problem is brewing. Once again, those on Wall Street and the Fed do not see the debt elephant in the room. Even worse, they see it but ignore that perpetuating the problem serves their interests best.

Spotting The elephant

In 2008, the sub-prime mortgage market crashed for several reasons. Chief among them, borrowers were ill-equipped to make mortgage payments if interest rates rose and/or incomes were compromised. Equally problematic, the collateral (home prices) backing the loans were grossly overvalued.

Federal debt, while vastly different than private debt, is equally unsustainable. The graph below quantifies the fiscal problem.

Over the last 15 years, debt has grown at seven times the rate of tax receipts and more than four times faster than economic growth. The divergence between federal debt and the ability to pay for it accelerated during the subprime crisis and is accelerating again due to pandemic-related multi-trillion-dollar deficits.

Are the odds of perpetually increasing the gap between spending and tax revenue any better than the Miami exotic dancer, featured in The Big Short, making good on her loans on five houses and a condo?