Interactive Investor

Viewpoint: Will Janet Yellen be any good in a financial crisis?

6th March 2014 10:42

Ken Fisher from ii contributor

You can't know with certainty - human thoughts and decisions are impossible to predict perfectly. But we do know what she did during the last one. Late last month, the Fed released transcripts of every meeting and conference call during 2008 - we now know everything Yellen said and didn't say. It isn't pretty.

The US Federal Reserve grossly mishandled the financial crisis. They never saw what was causing financial institutions to go under. Never used monetary tricks that always work when liquidity is tight. Never understood the destruction they caused by making Lehman Brothers go bankrupt. Now we know Yellen was complicit.

Even five-plus years later, few fathom what caused the financial panic. It wasn't a housing crash, subprime mortgages or "toxic assets". It was a simple accounting rule, FASB 157, which forced financials to mark every asset on their balance sheets to the current market value.

No matter how thinly traded, and even if they never planned to sell. If one bank sold something at bargain-basement prices, every bank had to write down the value of every comparable security they owned to that same value. This vicious circle of writedowns wiped about $2 trillion (£1.2 trillion) from the US banking system in mere months. Bank capital crated. Institutions stopped lending to each other. When they inevitably couldn't meet overnight funding requirements, they were deemed bankrupt - regardless of book value.

The Fed never grasped the significance of mark-to-market and the ensuing writedowns. Yellen sure didn't - transcripts show she thought the biggest economic risks were falling housing and high oil prices. She supported rate cuts early in the year, but by summer she saw a bottom and expected to hike by year-end.

She never suggested dropping the discount rate below the Fed Funds target so banks could borrow cheap from the Fed and lend to each other at higher rates - an age old central bank incentive to keep money moving. She had opportunities. The New York Fed's Spence Hilton noticed banks weren't playing discount window arbitrage in April, but no one connected the dots. They kept the discount rate 25 basis points above Fed Funds the whole time. Tight money policy.

Lehman Brothers

The worst came in September, after Lehman failed. The Fed made Lehman go bankrupt. It was purposeful. In March, when Bear Stearns was in the same situation, the Fed stepped in, helping JPMorgan buy them out. Markets expected the same with Lehman. It didn't happen, and transcripts confirm it was deliberate.

The day after Lehman filed for bankruptcy, St. Louis Fed President James Bullard praised colleagues for "denying funding to Lehman suitors". Richmond Fed President Jeffrey Lacker called it "obviously good", former Kansas City Fed President Thomas Hoenig and Boston Fed President Eric Rosengren deemed it "the right thing", and former Fed Governor Kevin Warsh said the decisions "not to provide official-sector money" should make everyone "feel good".

At the end of the meeting, they spent ages arguing over adverbs, debating whether to say they were "closely" watching markets or just plain watching. Jokes all around. None of them grasped the severity of the situation or implications of their action - they didn't fathom the uncertainty and panic they caused by making Lehman fail after the Bear merger and nationalisation of mortgage underwriters Fannie Mae and Freddie Mac. They still don't.

During that meeting, Yellen didn't say a word about Lehman. But she did give a glib economic outlook, joking about dentists, plastic surgeons and falling demand for country club memberships - way out of touch. She didn't support lowering interest rates when the banking system needed all the liquidity it could get. Not until October, already too late.

It's a perverse quirk of US bureaucracy that these transcripts weren't released before the Senate confirmed her as Fed Chair. Would they still have blessed her if they'd seen this? Shouldn't they get to weigh her actions instead of her politically practiced testimony? Couldn't the Fed have released these documents on 1 January, as soon as the five-year holding period passed? Did they have to wait till now?

On the bright side, Fed heads tend to wipe their brains after they take office. Many do the opposite of what their prior experience, statements and writings suggest. Maybe Yellen forgets everything that made her screw up in 2008 and acts sensible next time.

Bull market

Thankfully, next time should be far off - for now, a true test of her crisis responses doesn't appear near. Banks are sound, and today's regulations aren't anywhere near as destructive as mark-to-market. As long as Yellen or anything else doesn't get in the way, this bull should run on. Run with it with stocks like these:

In a bull market's second half, stocks with fat gross margins should do best. Swiss-based Nestle has lagged for years, but I like it now. Investors yawn: 17 times 2014 earnings seems high for food firms. How do I justify it? A foodie with 50%-plus gross margin boggles the mind. How does it do that? Super brands plus super management leads to super-reliable profitability - again, something later-stage bulls love as the later entrants digest their first stock bits in years. Buy it before they bite.

Intel lagged for years, too. I like that investors are used to being repulsed. People forget the obvious: 1) it's the prime generator of Moore's Law (our era's second most powerful force after raw capitalism), and 2) new CEOs, like Brian Kraznich, always clean house, depressing current earnings to boost future results (which markets love later). And 3) for such a competitive field, its 58% gross margin astounds. Now it's time - at 13 times my 2014 earnings estimate with a 3.5% dividend yield.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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