New York: Treasury secretary Henry M. Paulson Jr left his suite at Manhattan’s Waldorf-Astoria Hotel on 15 September after a sleepless night, feeling he’d done all he could to minimize the damage from that morning’s collapse of Lehman Brothers Holdings Inc., aides said.
Money fund: Bruce R. Bent, founder and CEO of Reserve Management. Bloomberg
At meetings concluded the previous evening 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 will repay their debts. And with the help of a rule change by Federal Reserve chairman Ben S. Bernanke, they were confident bank-to-bank loans would keep flowing. The general feeling was things were working, said Phillip L. Swagel, Paulson’s assistant secretary for economic policy, who remained in Washington that weekend.
Nobody accounted for Bruce R. Bent. The 72-year-old graduate of St John’s University in Queens, New York, created the first money market fund in 1971, the Reserve Primary Fund.
He touted it as an investment so safe it would lull clients to sleep—so safe that, even with $785 million (around Rs3,807 crore now) in loans to tottering Lehman, Bent and his wife had jetted to Rome that Sunday evening to celebrate their 50th wedding anniversary.
Bent’s $62.5 billion fund had lent money to Lehman, mostly by acquiring short-term notes called commercial paper, used by companies to pay everyday expenses such as utilities and payroll and by Wall Street to fund everything from takeovers to the mortgages it turns into bonds. Money funds like Bent’s are the biggest buyers of commercial paper, purchasing about 40% of outstanding issues, according to the Fed.
It was commercial paper and the $3.6 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, and 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 F. Geithner, 48, and Paulson.
Like ice-nine, the fictitious substance in Kurt Vonnegut Jr’s novel Cat’s Cradle, a single seed of which could harden all the world’s water, commercial paper was the crystallizing force that froze credit markets, choking off the ability of firms and banks to borrow money and pay bills.
That a 158-year-old investment bank with $613 billion in liabilities could go belly up made every institution seem vulnerable. Within hours, investors were yanking money out of funds that just the day before seemed impregnable.
The first victim was Reserve Primary. By 1pm on Monday, 15 September, in New York, less than 13 hours after the 12.37am bankruptcy announcement, client demands for immediate cash-outs totalled $18 billion, exceeding a quarter of the fund’s assets. Even more alarming, Reserve Primary’s bank, Boston-based State Street Corp., had quit honouring withdrawal requests.
The entire financial system was coming to a grinding halt incredibly rapidly, Robert P. Kelly, CEO of Bank of New York Mellon Corp., the world’s biggest custody bank, recalled in an interview nine months later. “At the time, I don’t think the average American really understood how bad things were.”
Just before 2pm on Monday, executives at New York-based Reserve Management Co. concluded that no one was willing to help them raise cash by purchasing their Lehman commercial paper.
“Paulson and Bernanke totally f—ed this up,” Reserve chief investment officer Patrick R. Ledford said on a call with three colleagues, according to a transcript of the conversation obtained by the US Securities and Exchange Commission and posted on the agency’s website. “I don’t think they thought this goddamned thing through, to figure out what the rippling effects would be”.
Paulson and Bernanke both declined to comment. Michele Davis, Paulson’s assistant secretary for public affairs, defended her boss. Nobody can point to what we could have done differently, Davis said. History will bear it out.
In a sign of distress, the yield of overnight commercial paper for top-rated non-financial companies climbed to 3.43% on that Monday, from 2.12% on Friday, 12 September, according to the Fed.
It was the biggest one-day jump since the central bank began tracking the statistic in 1997.
By the end of the week, $230 billion was gone from the industry, according to Crane Data Llc.
The market was frozen, and nobody could buy or sell, said Jack Winters, a retired 33-year veteran of the industry who worked for Federated Investors Inc., Fidelity National Financial Inc. and Lehman. The only bids were low-ball. How do you set prices for securities in that environment?
Money funds aim to maintain what’s called a net asset value, or NAV, of $1. That means every dollar an investor puts in is worth at least a dollar at all times. Gains are credited to customers and distributed monthly as cash or new shares. If a fund’s share value drops below $1 because of an investment loss, it’s called breaking the buck.
When news that Reserve Primary broke the buck hit the wires at 5.04pm that Tuesday, the race was on. It was already too late for Willard Scolnik, a 78-year-old retired architect in Palm Harbor, Florida.
Scolnik was visiting his son Stuart in Washington on 16 September. He was watching a financial news channel a little after 5pm with his son’s dog, Bella, on his lap when he heard that Reserve Primary had fallen below $1.
He flipped open his phone and started dialling.
Scolnik said his $400,000 in the fund was earmarked for living expenses and a lung transplant for his other son, David.
“My reason for being with Reserve Primary was they were supposed to be conservative, and they told us that we could sleep well knowing they would do nothing to cause us any pain,” Scolnik said of the fund. So, big shock.
By late Thursday night, the Treasury and Fed were ready to stop the carnage. The next morning, 19 September, the government announced a temporary guarantee for money market funds, a $50 billion insurance programme that backed all shares.
The backstop remains in effect through 18 September.
Though his son David’s health has deteriorated, Scolnik said he hasn’t yet needed a lung transplant. Scolnik is suing to recover the $50,000 he didn’t get back after Reserve liquidated its assets.
“It makes me feel awful, vulnerable, he said. Next time I won’t trust anyone.”
Christopher Condon in Boston contributed to this story.