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3 Of The Fed's Biggest Bets

3 Of The Fed's Biggest Bets

There can be little argument that the U.S. Federal Reserve saved the banking system and, in the process, the global economy during the credit crisis. In an intense time with the financial system seemingly coming apart at the seams, Bernanke & Co. pulled out all the stops in order to keep the country from an abject disaster.

Gentle Ben and his merry band of central bankers cut rates time and time again. They changed some rules and offered up an alphabet soup of new programs to keep banks solvent. In the end, they even printed money to keep the country out of what would have surely been history's darkest days from an economic standpoint.

Once the danger of imminent collapse had passed, Bernanke's Bunch then had to turn their attention to keeping the U.S. from entering a Japanese-style deflationary cycle.

Having studied every detail of the Great Depression, Bernanke knew that once deflation took hold of an economy, it was almost impossible to stop. So, after years of "fighting inflation" -- as in keeping it low -- the Fed decided that a little inflation would be a good thing and set out to reflate the economy.

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If investors are looking for someone to thank when looking at their 401K statements or the value of their home, they need look no farther then Ben Bernanke and the rest of the FOMC members. It was their creative handiwork that ultimately saved the day.

Make no mistake about it: There were some very big gambles with very large stakes involved, and the Fed's latest big bet is about to come into play.

Three Big Bets - Two Big Wins (So Far)

In essence, the Federal Reserve wound up making three ginormous bets to the tune of about $3.2 trillion.

Yep, that's right: The Federal Reserve has spent more than $3.2 trillion since 2008 on its efforts to save the economy/banking system as the Fed's "balance sheet" went from less than $1 trillion before the crisis to more than $4.2 trillion as of last week.

The good news is that two of the three big bets appear to be winners at this stage, but it's the third one that has investors worried these days.

Bet #1: We Can Save the Banking System from Collapse

First, Bernanke's gang bet that they could find a way to keep the banking system from collapsing during the crisis. Bear Stearns was gone. Lehman had fallen. Merrill was in a world of hurt. Heck, even Goldman Sachs needed Warren Buffett to ride in on his white horse to save their bacon during that tumultuous few weeks.

While it was a very close call (many believe that money market funds "breaking the buck" would have caused the financial system to buckle and break), the Fed changed some rules (anybody remember a little thing called "mark to market?"), opened up the bank's vault, made some deals and twisted a few arms in order to ultimately get the job done.

In short, this was a very big win. Unfortunately, it was akin to simply keeping the patient from bleeding out in the Emergency Room. No, it turns out there were other large problems to contend with. On to Big Bet #2...

Bet #2: We Can Keep the Economy Out of Deflationary Cycle

Next, the Fed bet that they could keep the U.S. from entering a deflationary cycle. The good news was that the banks weren't going to collapse, but with stocks cratering and the value of real estate plummeting, Bernanke and friends knew they still had a great deal of work to do.

S&P 500 Weekly During The Credit Crisis


iShare Real Estate (IYR) Weekly During The Credit Crisis


So, the Fed cut rates. Then they cut rates again. And again. And again -- until there was nothing left to cut. However, the economy just couldn't seem to get up off the mat.

The problem was that beginning in 2010, new crises cropped up with regularity. The bottom line was that each new crisis caused the economy to stop on a dime. First there was Greece. Then there was, well, Greece. Then there was Ireland, Italy, Portugal and Spain. Then there were the self-inflicted wounds from the boys and girls in Washington. And then there was ... you get the idea.

Those Darn Europeans!

Many, including your truly, contend that if the European debt crisis hadn't caused investors to freak out every six months, the first round of Fed stimulus would have likely done the trick. But with it looking like the bad old days of the crisis were returning every spring, the economy just couldn't gain any momentum and the threat of recession remained constant.

In response, the Bernanke crew came up with something called "Quantitative Easing." The idea was for the Fed to buy up existing bonds and other securities every week in order to pump liquidity into the system. This was intended to keep rates low and to force those freshly minted dollars to be "put to work" in the economy somewhere.

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It is important to realize that although the idea of quantitative easing definitely wasn't new, employing the tactic on a mass scale was a bit of an experiment (i.e., a big bet!) for the U.S. Federal Reserve.

While analysts are likely to argue about this tactic for decades to come, the bottom line is the implementation of QE programs I, II and III (or were there actually four or five?) has indeed kept interest rates low and pushed asset prices (think stocks, bonds and real estate) higher.

As the chart below clearly illustrates, it has been a pretty good time to own stocks and real estate.

S&P 500 Weekly From 2009


One of the oldest sayings on Wall Street is "Don't fight the Fed." This is especially true when they are "on a mission." With the Fed clearly on a mission to reflate the economy and increase asset prices, it's been a good ride in the stock market. Owning real estate hasn't been too bad an idea either.

iShares Real Estate (IYR) Weekly From 2009


So, while the game's not quite over, it's been so far, so good on this bet.

Bet #3: We Can Return Rates to "Normalized" Levels Without Issue

Finally, the Fed is betting that with the economy looking like it is finally on a growth path (fingers crossed!), they will be able to remove the myriad of stimulative efforts without the stock or bond market tanking.

Next time we'll talk about the final and very big bet the Fed is making.

Tags: 401K credit crisis FOMC Quantitative Easing Warren Buffett

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