AFTER A sleepless night, US treasury secretary Henry Paulson left his suite at Manhattan's Waldorf-Astoria Hotel on September 15 last year. He had done all he could to limit the damage from that morning's collapse of Lehman Brothers.
At meetings concluded the previous evening, Sunday, at the Federal Reserve Bank of New York, Paulson and executives of the world's largest financial institutions worked to head off two threats they anticipated in the wake of the biggest bankruptcy in US history.
The bankers spent hours trying to unwind Lehman-related credit-default swaps, bets made on whether companies would repay their debts. And with the help of a rule change by the Federal Reserve's chairman, Ben Bernanke, they were confident bank-to-bank loans would keep flowing.
"The general feeling was things were working," said Phillip Swagel, Paulson's assistant secretary for economic policy, who remained in Washington that weekend.
Nobody accounted for Bruce Bent, the 72-year-old who created the first money market fund, the Reserve Primary Fund, in 1971.
He touted it as an investment so safe it would lull clients to sleep - so safe that, even with $US785 million in loans to tottering Lehman, Bent and his wife had flown to Rome for their 50th wedding anniversary.
Bent's $US62.5 billion fund had lent money to Lehman, mostly by acquiring short-term notes called commercial paper, used by companies for everyday expenses such as power bills and payrolls and by Wall Street to fund everything from takeovers to the mortgages it turns into bonds. Money funds such as Bent's are the biggest buyers of commercial paper, purchasing about 40 per cent of outstanding issues, according to the Fed.
It was commercial paper and the $US3.6 trillion money market industry that traded the notes that came close to sinking the global economy - not a breakdown in credit-default swaps or bank-to-bank lending. The bankers were focused on saving themselves. Commercial paper, as invisible as the air they breathed, never came up at the meetings, according to one of the two dozen executives invited to the New York Fed by its president, Timothy Geithner, 48, and Paulson.
Commercial paper was the crystallising force that froze credit markets, choking off the ability of companies and banks to borrow money and pay bills.
That a 158-year-old investment bank could go belly-up with $US613 billion in liabilities made every institution seem vulnerable. Within hours, investors were yanking money out of funds that the day before seemed impregnable. This was not noticed by most market
participants at first, said Mohamed El-Erian, chief executive officer of Pacific Investment Management Co, the world's largest fixed-income fund manager. "Monday and Tuesday, people didn't quite see what was happening," El-Erian said in July. "You had to be on the desk in the payments and settlements system, cash and collateral, to start seeing cascading market failures and a complete erosion of trust."
The first victim was Reserve Primary. By 1pm on Monday, September 15, in New York,
less than 13 hours after the 12.37am bankruptcy announcement, client demands for immediate cash-outs totalled $US18 billion, more than a quarter of the fund's assets.
Even more alarming, Reserve Primary's bank, State Street Corp, had stopped honouring withdrawal requests.
"The entire financial system was coming to a grinding halt incredibly rapidly," Robert Kelly, the chief executive of Bank of New York Mellon Corp, the world's biggest custody bank, recalled. "At the time, I don't think the average American really understood how bad things were."
On commercial paper desks all over Wall Street that Monday morning, phones that normally buzzed with employees renewing overnight loans were hushed. At the headquarters of Wal-Mart Stores there was
more activity. Wal-Mart had $US250 million in Reserve Primary that it could not get out. Visa USA had $US982 million.
For years Bent had shunned commercial paper as too risky and scolded managers of other funds for sacrificing safety to earn higher yields, said Peter Crane of Crane Data. Commercial paper is unsecured - there is no collateral to seize if the borrower does not pay up.
In August 2007 the commercial paper and other credit markets froze as a result of deteriorating mortgage values. Banks such as Citigroup had funded the home loans in their structured investment vehicles, or SIVs, with commercial paper, and now the off-balance-sheet pools were collapsing because investors stopped buying the short-term notes. SIV managers put their debt up for sale for as little as half the face value. Bent went on a buying spree.
"When they dumped it out into the marketplace, there were cats and dogs, and there were snakes, but there were also pearls," the white-haired Bent said in an interview with Bloomberg in June 2008. "So I go through and I pick out the carrots and the peas, and the rest of the stuff I let it go."
From July 2007 to July 2008, the commercial-paper portion of Reserve Primary's holdings jumped to almost 60 per cent from 1 per cent, according to the trade association. The fund's yield rose, in turn attracting more customers. Net assets in the fund grew to $US67 billion in July 2008 from about $US30 billion a year earlier.
One of the "peas" Bent acquired was debt issued by Lehman in August 2007. The Lehman investment eventually rose to $US785 million. On September 15, as his flagship fund was sinking under the surge of redemption requests, Bent was speed-dialling from Rome. "I'm not clairvoyant," Bent said. "I didn't know Lehman was going to go under."
Colorado Diversified Trust, a local government pool to park cash for fixing footpaths or hiring librarians, had bought $10 million of Lehman commercial paper on September 12, said Bob Hullinghorst, treasurer of Boulder County. Three days later the investment was worthless.
The biggest credit-rating firms - Standard & Poor's, Moody's Investors Service and Fitch Ratings Inc - gave Lehman commercial paper their highest grades to the end.
Money funds are accustomed to clients, especially big institutions, moving cash in and out. Yields are so low that investors switch billions if a fund loses a single basis point, or 0.01 of a percentage point, compared with a rival. Cash that comes and goes is nicknamed "hot money".
Most funds keep a portion of their assets in cash to satisfy redemption requests. Money was leaving so fast on September 15 that it was impossible to keep up.
Money funds aim to maintain what is called a net asset value, or NAV, of $US1. That means every dollar an investor puts in is worth at least a dollar at all times. If a fund's share value drops below $US1 because of an investment loss, it is called "breaking the buck".
To calculate the NAV, a fund's trustees need to be able to assign a value to their holdings. The previous week, Reserve Primary valued its short-term Lehman loans at 100 per cent. On September 15, the fund determined they were worth 80c on the dollar. To pay all the investors who demanded money, the fund needed to sell assets. It couldn't.
"The market was frozen and nobody could buy or sell," said Jack Winters, a retired 33-year veteran of the industry. "The only bids were low-ball. How do you set prices for securities in that environment?"
All funds that did not invest exclusively in US Government securities and needed to sell assets to meet client redemptions effectively broke the buck, Winters said.
Paulson, back in Washington, had other worries. American International Group, then the world's biggest insurer, was on the verge of a meltdown caused by bets its financial products division had made on credit-default swaps. The next day the government bailed it out with as much as $US85 billion, reversing its position on saving failing institutions and making Lehman the sole systemically vital firm to fail under Paulson's and Geithner's watch.
Money market funds flew under Paulson's radar because they were considered cautious, said David Nason, the then assistant treasury secretary for financial institutions. "The commercial paper market is largely unregulated. It's a nebulous area of credit that isn't under the umbrella."
On Tuesday, September 16, the run on Reserve Primary continued. Between Lehman's Chapter 11 announcement and 3pm on Tuesday, investors asked for $US39.9 billion, more than half of the fund's assets, according to Crane Data.
Reserve's trustees told employees to sell the Lehman debt. They could not find a buyer. At 4pm, the trustees determined that the $US785 million investment was worth nothing. With all the withdrawals from the fund, the value of a single share dipped to 97c.
"They had Lehman and hot money - that's a bad combination," said one asset manager. "Just the fact that this could possibly happen sent ripples through the industry."
Only one other fund had ever broken the buck - the much smaller Community Bankers Mutual Fund in 1994.
Mark Schild, president of Beech Hill Securities, which had clients invested in the fund, said others that broke the buck ''all had big institutions to feed them money. Reserve didn't."
When news that Reserve Primary broke the buck hit the wires at 5.04pm that Tuesday, the race was on.
"The best way to get your dollar back is to ask for it before anybody else," said Roger Merritt, who heads the fund-rating team at Fitch in New York.
Bank deposits were insured to $100,000 but money market funds were not insured at all.
By September 17, investors had taken $US78.7 billion out of money funds, according to Crane Data. By week's end, $US230 billion was gone from the $US3.6 trillion industry.
On the Wednesday, Paulson ordered senior adviser Steven Shafran to lead a team to devise a plan for stemming the run in the money markets. By late Thursday night, the Treasury and Fed were ready to stop the carnage. On the Friday morning, the government announced a temporary guarantee for money market funds, a $US50 billion program that backed all shares.
The European Central Bank also stepped in to aid European banks left without a source of funding when the US freeze spread across the Atlantic. European financial institutions accounted on average for more than a fifth of the commercial-paper holdings of the 15 largest US money funds last year.
"Industry assets might still be frozen today if the Treasury had not guaranteed all money funds and if the Fed had not provided a number of liquidity sources," Winters wrote to the Securities and Exchange Commission in July. After two panics in two years, the SEC has proposed new rules to govern money markets.
"The widespread run on money market mutual funds has underscored the dangers of institutions with no capital, no supervision and no safety net," the Group of 30, a financial advisory organisation that includes the former Fed chairman, Paul Volcker, reported in January.
But not everyone is convinced it will work. "The current proposed rule amendments will decrease the risks of money market funds but would not prevent another Reserve-style panic," said Peter Rizzo, director of fund ratings at S&P in New York. "If you want a scenario where nobody ever loses money again in the money market funds, that won't happen."
Bloomberg
