Editor’s note, October 9, 2013: After months of uncertainty and deliberation, President Obama has indicated that Janet Yellen is indeed his nominee to lead the Federal Reserve. The Center’s recent profile of Yellen provides an illuminating road map of what bankers, investors and markets can expect from the academic economist now ascending to one of Washington’s most influential posts.
Janet Yellen is in the running to become chairwoman of the Federal Reserve and that has many bankers and Wall Street titans worried.
The diminutive vice chairwoman of the U.S. central bank — an academic economist who is married to a Nobel Prize-winning economist — is known to be a formidable intellect and a force on the interest rate-setting Federal Open Market Committee. Her views on financial market regulation — an area where she’d have tremendous power as leader of the central bank — are less well-known.
“Her strengths are as an economist and thinking about macroeconomic policy and monetary policy,” said Tony Fratto, a former Treasury assistant secretary under President George W. Bush. “There’s no question that’s where the bulk of her experience is.”
The Center interviewed Yellen and reviewed her career through two stints on the Federal Reserve Board and as president of the San Francisco Fed Bank — including speeches, meeting transcripts, government testimony and reviews of bank failures.
The picture that emerges is of an overseer who tried to point out dangers in the banking system before the situation came to a crisis in 2008, but who didn’t act forcefully against banks that she saw taking excessive risk because she didn’t believe she had adequate authority.
After working through the depths of the crisis and having a hand in closing more than a dozen failed banks — including Washington Mutual, the largest bank failure in U.S. history — Yellen now appears determined to ensure that banks fortify themselves against financial shocks and that regulators have the power to police the system.
Yellen is unlikely to push for revolutionary change, such as breaking up the biggest banks.
The Fed so far “has taken the view that we need the rules not to change too much,” said Simon Johnson, a professor at the Massachusetts Institute of Technology, who supports making banks smaller.
However, many expect her to be a tougher regulator than the current Fed chairman, Ben Bernanke, and she appears more willing to take strong action to stop banking giants from putting taxpayers at risk. But even so, the power of the Fed has its limits.
“They can’t stop all future crises, but it’s up to the Fed to make these crises more or less severe,” said Johnson, author of "13 Bankers: The Wall Street Takeover and the Next Financial Meltdown."
Bernanke’s term ends at the end of this year and President Barack Obama has suggested that he may replace him.
Yellen wants to require big banks to hold more capital, to boost the margin requirements on derivatives trades and to require foreign banks that do business in the U.S. to hold capital in the U.S.
“We would expect her to toughen rules for the biggest banks,” said Jaret Seiberg, analyst at Guggenheim Strategies in New York, in a client report. “We believe her elevation to chairman would be negative for the mega banks.”
Dealing rare loss to Greenspan
Yellen was first appointed to the Federal Reserve Board in 1994 when Alan Greenspan was chairman. She was at the Fed less than a year when she dealt Greenspan his first and only defeat in a vote over his 18 years at the helm.
The Fed’s Board of Governors was set to vote at a rare open meeting in 1995 to require banks to use a uniform formula to inform consumers of the true rate of return on bank certificates of deposit. Yellen and then-Vice Chairman Alan Blinder were opposed.
“The formula was wrong. It was just wrong,” Yellen said in an interview in her office. “I couldn’t stand it.”
On her way to the meeting, she complained to another governor about the faulty formula, invoking the image of her mother whose savings was in CDs. When it was time to vote, Greenspan had three yeas to Yellen’s four nays.
That Yellen dealt the notoriously laissez-faire chairman his one defeat in a vote on bank regulation is both amusing and telling.
“On the pro-regulation, anti-regulation spectrum, if we imagine such a thing, she is miles away from Alan Greenspan,” said Blinder.
Yellen left the Fed board in 1997 to become chairwoman of President Bill Clinton’s Council of Economic Advisers, and then she returned to academia.
In 2004, she was tapped to be president of the Federal Reserve Bank of San Francisco when the housing boom, especially in California, Nevada and Arizona, was in full swing. In that role, she had oversight of bank holding companies in nine Western states as well as smaller state banks that were members of the Federal Reserve System.
The Federal Reserve System is made up of the Washington, D.C.-based Board of Governors and 12 Reserve Banks located across the country. The seven-member board in Washington writes bank regulations and the reserve banks have supervisors to enforce the rules in their districts.
Countrywide Financial — based in Calabasas, Calif. — had announced its mission was to “dominate real estate finance.” Smaller regional banks were lending like crazy to real estate developers. Yellen was alarmed by what she saw, she said in testimony to the Financial Crisis Inquiry Commission in 2010.
She and her team brought their concerns to the Federal Reserve Board in Washington, she told the commission. It’s the board — then led by Greenspan — that sets regulatory policy, and the reserve banks carry it out. Under Greenspan, that policy became known in the banking industry and inside the Fed as “Fed-Lite.”
Trouble in California
“We felt that, in San Francisco, supervision is a delegated activity and we operate under the guidelines of supervision that are given to us by the Board of Governors,” she testified to the FCIC. “Could we have used our own discretion? I don’t think we felt we had the power to do that.”
Leaders at the Fed board in Washington weren’t inclined to rein in banks when they were making loads of money on a rising real estate tide.
“A lot of the economists at the Fed thought that things were pretty good, and that supervisors shouldn’t meddle in financial markets,” said Richard Spillenkothen, who was head of bank supervision at the Fed until 2006. Many of the regional bank presidents were of the same view, he said.
Yellen was among the handful that showed an interest in bank oversight, Spillenkothen recalls, and was one of a small group of regional presidents who met with the Fed board’s regulatory policy and supervision staff when she was in town for meetings of the Federal Open Market Committee. The FOMC sets interest rates and includes the governors based in Washington and a rotating roster of presidents of the Fed’s 12 reserve banks.
Even with the constraints she felt, Yellen appears to take pride in how stringent San Francisco was under the circumstances. Countrywide Financial CEO Angelo Mozilo in late 2007 converted his company from a bank holding company to a thrift in what experts said was a case of regulator shopping. The Office of Thrift Supervision had a reputation as a light regulator.
“I like to think that we were tough in our supervision, so they wanted to be supervised by someone else,” Yellen said in her 2010 testimony.
Mozilo flew his company’s jet from the company’s Calabasas headquarters to San Francisco to tell Yellen personally that he was taking his business to the OTS.
Critics say she could have done more.
“There is little evidence that she took steps to contain the out-of-control housing bubble in the district of the San Francisco Fed when she presided over that bank from 2004 to 2010,” said Linus Wilson, a professor at the University of Louisiana, who studies and writes about bank bailouts. “Her current, long record at the Fed indicates that she will preside over a Fed that lets the Wall Street banks gamble unchecked at the expense of U.S. taxpayers.”
Yellen herself acknowledges she didn’t see risks to the overall financial system, even as she was concerned about some banks in California.
“I did not see and did not appreciate what the risks were with securitization, the credit rating agencies, the shadow banking system, the SIVs,” she told the FCIC, referring to the offshore “structured investment vehicles” used by some financial institutions to move mortgage securities off their balance sheets. “I didn’t see any of that happening until it happened.”
But she was worried about the fast and loose financing that was going on at the time.
Risky piggyback loans
Transcripts of speeches and FOMC meetings show that Yellen was among those who raised concerns about risky mortgages, including interest-only loans and adjustable rate mortgages, as early as 2005.
“One of the things we’re seeing in California and elsewhere in our District—and maybe this is true nationwide—is a growing use of piggyback loans. Loan-to-value ratios of 90 to 95 percent are common in California, and we’ve even seen combination loan-to-value ratios and piggyback loans going up to 125 percent,’’ she told the FOMC in June of that year. She said such loans could threaten Fannie Mae and Freddie Mac, the housing finance giants that were taken over by the U.S. government in the summer of 2008 because of massive mortgage losses.
It took more than another year before the Fed and other regulators warned banks of the dangers of such mortgages .
Yellen, in the interview, said the guidance was inadequate. “After all these years and with the commercial real estate problem now about to start blowing up, we get a piece of guidance that focuses on risk-management practices.”
She was more candid in her FCIC testimony. “You could take it out and rip it up and throw it in the garbage can. It wasn’t of any use to us.”
By early 2008, Yellen could see firsthand how the deterioration of California’s real estate market was harming its banks. IndyMac, a bank that was deep into subprime lending and was supervised by the Office of Thrift Supervision, came to the Fed to borrow at the discount window.
All depository institutions have to have reserves at the Fed to ensure they can pay when customers want to withdraw their cash. If the reserves fall short at the end of a business day, they take an overnight loan from another bank. If other banks refuse to lend, the bank can borrow from their regional Fed’s discount window at a higher interest rate. The Fed also lends to troubled banks to allow them to function for a short time while regulators prepare to shut them down.
When banks borrow from the Fed — which is known as the lender of last resort — the central bank demands high quality collateral.
During the financial crisis, banks became unwilling to lend to one another because they feared they wouldn’t be repaid, so borrowing at the discount window became routine. As IndyMac’s condition worsened, Yellen sent her top examiners in to get a better look at the collateral the bank had posted — mostly mortgage and home equity loans.
“We were really disgusted,” she recalled in the interview. “This collateral was worth far less than face value.”
In July 2008, IndyMac failed and was seized by the FDIC.
Biggest bank failure ever
By then it was also apparent that Washington Mutual, another OTS-regulated bank in Yellen’s district, was struggling to survive. With more than $300 billion in assets, WaMu was an order of magnitude larger than IndyMac. It had been borrowing from Yellen’s Fed bank since December 2007 and by August it owed $2 billion, according to data released by the Fed and compiled by Bloomberg News. Depositors were withdrawing their money and borrowers were defaulting.
Yellen took the matter into her own hands. She called CEO Kerry Killinger and told him that if he wanted access to her discount window, he would have to allow Fed examiners into the bank to see the files on all loans he intended to post as collateral.
“We didn’t trust the OTS,” she said. “The OTS never told us what the state of these institutions was.”
When WaMu was seized by the FDIC on September 25 and sold to JPMorgan Chase, the Fed was repaid in full.
Supervision at the San Francisco Fed wasn’t without its faults.
The 12th district saw 13 of its banks fail from the day that Lehman Brothers declared bankruptcy in 2008. In almost every case, the banks had huge concentrations of construction and commercial real estate loans on their books, loans that defaulted disproportionately when the real estate markets in the Western states collapsed.
The Fed’s inspector general issued reports on most of those failures. When Merced, Calif.-based County Bank collapsed, costing the FDIC $135.8 million, the inspector general said the San Francisco Fed supervisors could have done more.
“We believe that the magnitude and significance of County's asset quality deterioration and credit administration deficiencies that emerged in the summer of 2007, coupled with management's disagreement with regulators, warranted a more direct and forceful supervisory response by FRB San Francisco,” the report said. The inspector general went on to say that because of the collapse of real estate values, the bank might have failed anyway.
Overall the San Francisco Fed Bank had the third-highest number of bank failures during the crisis of all the Fed district banks, after Chicago and Atlanta.
And Wells Fargo, the biggest bank under the supervision of the San Francisco Fed, borrowed $25 billion under the 2008 bank bailout known as the Troubled Asset Relief Program.
“Looking back, I believe the regulatory community was lulled into complacency by a combination of a Panglossian worldview and benign experience,” Yellen said in a speech in Denver in 2010.
“This experience has strongly inclined me toward tougher standards and tighter rules,” she testified in 2010.
When Obama asked Yellen to come back to Washington to serve as the Fed’s vice chairwoman in 2010, she was fresh from the trenches of dealing with the real estate crash and collapsing banks. She saw for herself where bank regulation and supervision failed.
She says the crisis made it clear that regulators weren’t simply too lenient, they also weren’t looking at the system in the right way.
At the Fed board in Washington, Yellen leads the group that does research on systemic risk in the overall financial system. She said she sees the current strategy — strengthening banks and ensuring there’s a way to deal with them if they collapse — as a “belt and suspenders” approach.
“We don’t want these entities to fail. We want to make them much more robust and less likely to come under pressure,” she said. ”Then if something did happen, we would have a way to deal with it that we were not able to do during the financial crisis.”
And while the vast majority of her public speeches still focus on the U.S. and global economies, she has occasionally addressed the financial system and regulation.
She said in the interview that she doesn’t favor breaking up too-big-to-fail banks, but would demand they hold more capital than international regulators now propose. The so-called Basel committee of global regulators has suggested a capital ratio 2.5 percentage points higher for financial institutions deemed systemically important.
And she supports the Fed’s proposal to require foreign banks that operate in the U.S. to organize U.S.-based holding companies that meet U.S. capital requirements, a plan that foreign banks and European Union officials oppose.
In a letter to Bernanke, the EU Commissioner for Internal Markets Michel Barnier called the proposal a “radical departure” from previous rules that could “result in a competitive disadvantage” for foreign banks.
In a January speech, Yellen got on the wrong side of derivatives traders.
Derivatives are financial contracts that investors use to bet that the price of a certain equity, commodity or other instrument will rise or fall as of a future date. Traditionally derivatives are used to hedge against price swings in commodities such as oil, corn or interest rates.
Before the financial crisis, however, investors created derivatives to bet on almost anything, from changes in the weather to the likelihood that Lehman Brothers would default on its debt. The face value of derivatives reached $596 trillion in 2007, about four times the value of all the financial assets in the world. Derivatives of mortgages played a role in the financial crises, and credit default swaps — a type of derivative — caused the collapse of insurance giant American International Group.
Post-crisis rules now require standard derivatives be traded through an exchange, where investors will have to provide capital to guard against losses during the term of the contract. They can get around the rules, however, by creating custom contracts.
Yellen says she wants to require companies that trade derivatives over the counter to post initial margin to ensure they can meet future losses, as well as posting interim margin if the value of the trade falls. Making the contracts more expensive might also encourage traders to go back to the exchange.
“Even in light of the significant costs of initial margin, it seems clear that some requirements are needed,” she said.
“We still harbor grave concerns about the initial margin requirements,” four trade associations wrote in a letter to global bank regulators. “The IM requirements do not appear to meet any objective cost-benefit analysis.”
Industry objections might actually boost Yellen’s chance of being nominated.
“It would be hard to envision President Obama naming anyone as fed chair who wouldn’t be tough on the banks,” Seiberg of Guggenheim Partners said in an interview. “All the political pressure in the world remains in favor of making sure the biggest banks have lots of capital and have changed their business practices so we don’t get another crisis. Yellen fits the mold.”