In the second part of our series on how the collapse of Lehman Brothers sparked a global financial meltdown, we examine why panic gripped money markets in the hours after the investment bank fell.
US Treasury Secretary Henry Paulson left his suite at Manhattan's Waldorf-Astoria Hotel on September 15 last year after a sleepless night, feeling he'd done all he could to minimise the damage from that morning's collapse of Lehman Brothers Holdings.
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 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 Bernanke, they were confident bank-to-bank loans would keep flowing.
Nobody accounted for Bruce 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 US$785 million ($1.1 billion) in loans to tottering Lehman, Bent and his wife had jetted to Rome that Sunday evening to celebrate their 50th wedding anniversary.
Bent's US$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 St to fund everything from takeovers to the mortgages it turns into bonds.
It was commercial paper and the US$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 Geithner, and Paulson.
Like ice-nine, the fictitious substance in Kurt Vonnegut's 1963 novel Cat's Cradle, a single seed of which could harden all the world's water, 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 Lehman, a 158-year-old investment bank with US$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, September 15, in New York, less than 13 hours after the 12.37am bankruptcy announcement, client demands for immediate cash-outs totalled US$18 billion, more than a quarter of the fund's assets.
Even more alarming, Reserve Primary's bank, Boston-based State Street, had quit honouring withdrawal requests.
"The entire financial system was coming to a grinding halt incredibly rapidly," Robert Kelly, CEO of Bank of New York Mellon, recalls. "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 concluded that no one was willing to help them raise cash by purchasing their Lehman commercial paper. "Paulson and Bernanke totally f****d this up," Reserve chief investment officer Patrick 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."
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."
WAL-MART FREEZE
On commercial paper desks all over Wall St that Monday morning, phones that normally buzzed with employees renewing overnight loans were hushed.
At the Arkansas headquarters of Wal-Mart, there was more activity. Wal-Mart had US$250 million in Reserve Primary that it couldn't get out.
Henry Ford Health System in Detroit and its affiliates had US$414 million. San Francisco-based Visa USA had US$982 million.
All eyes in the industry were on Reserve because it was the fastest-growing group of funds and because of Bent's stature, said Peter Crane, president of Crane Data, which tracks the money market.
For years, Bent had shunned commercial paper as too risky and scolded managers of other funds for sacrificing safety to earn higher yields, Crane said. Commercial paper is unsecured, meaning there is no collateral to seize if the borrower doesn't pay up.
Then, 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 purchasing their short-term notes. When SIV managers put their debt up for sale for as little as half the face value, Bent went on a buying spree.
'CARROTS AND PEAS'
"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 last year. "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.
One of the "peas" Bent acquired as part of his move into commercial paper was debt issued by Lehman in August 2007. The Lehman investment eventually rose to US$785 million.
By early September 2008, Reserve Primary was the third-highest-yielding money fund out of 227 in the US, according to Crane. Bent, he said, "was on top of the world".
On September 15, while his flagship fund was sinking under the surge of redemption requests, Bent was speed-dialling from Rome.
"I'm not clairvoyant," Bent said later. "I didn't know Lehman was going to go under."
Colorado Diversified Trust, a pool created by local governments to park cash before using it to fix footpaths or hire librarians, had bought US$10 million of Lehman commercial paper on September 12, said Bob Hullinghorst, treasurer of Boulder County. Three days later the investment was worthless, he said.
The biggest credit-rating firms - Standard & Poor's, Moody's Investors Service and Fitch Ratings - all gave Lehman commercial paper their highest grades to the end.
"If people can't rely on a top rating because the regulators aren't there to supervise that and the agencies are not providing accurate ratings, where can we go?" said Hullinghorst, whose county wrote off US$687,000 it had in the Colorado Diversified Trust.
In a sign of distress, the yield of overnight commercial paper for top-rated non-financial companies climbed to 3.43 per cent on Monday, September 15, from 2.12 per cent on Friday, September 12, according to the Fed. It was the biggest one-day jump since the central bank began tracking the statistic in 1997.
Money funds are accustomed to clients 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 even has a nickname: "hot money".
While no rules mandate the practice or the amount, 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.
By 1 pm New York time, Bent had called into three of his own trustees' meetings from Italy. The SEC alleges that Bent and his son, Reserve president Bruce Bent II, committed fraud that week by misleading investors and trustees about the extent of losses in the fund and their ability to raise cash to prevent its collapse.
Both Bents have denied the charges in court filings.
Money funds aim to maintain what's called a net asset value, or NAV, of US$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 US$1 because of an investment loss, it's 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 US80c on the dollar. The problem was, 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 who worked for Federated Investors, Fidelity National Financial and Lehman. "The only bids were low-ball. How do you set prices for securities in that environment?"
AIG BAILOUT
All funds that didn't invest exclusively in US Government securities and needed to sell assets to meet client redemptions effectively broke the buck, Winters said.
"If you had to liquidate the portfolio there and then, you wouldn't have had enough assets to redeem at US$1 a share."
Paulson, who flew back to Washington from New Jersey's Teterboro Airport at 9.50am on September 15, had other worries. American International Group, then the world's biggest insurance company, 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 would bail out the insurer with as much as US$85 billion, reversing its position about saving failing institutions, making Lehman the sole systemically vital firm to fail under Paulson and Geithner's watch.
Money market funds flew under Paulson's radar because they were considered cautious, said David Nason, Assistant Treasury Secretary for Financial Institutions at the time.
"The commercial paper market is largely unregulated," Nason said. "It's a nebulous area of credit that isn't under the umbrella."
At 5.45pm on September 15, General Electric chief executive Jeffrey Immelt met for half an hour with Paulson in the Treasury Secretary's office.
At 7pm, Geithner convened a staff meeting at the New York Fed to focus on "GE issues", and he and Paulson conferred by phone afterwards.
When Paulson and Geithner were searching for ways the previous weekend to mitigate the suffering that would follow a Lehman bankruptcy, they called on bankers. They didn't call on GE Capital, GE's finance unit, for advice. And when the bankers mapped out solutions, they hadn't accounted for GE Capital.
Now regulators had to deal with Immelt, a New York Fed board member. GE Capital said it had borrowed US$97 billion in commercial paper as of June 2008, more than any company or bank in the world.
Immelt eventually won approval for special Government guarantees on up to US$126 billion of borrowing, including backing for its commercial paper.
The episode humbled GE Capital, dragging down GE shares to a low of US$6.66 on March 5 from US$26.75 on the Friday before Lehman's bankruptcy. They have since rebounded to about half their September 12, 2008, value.
On Tuesday, September 16, the run on Reserve Primary continued.
Between the time of Lehman's Chapter 11 announcement and 3pm on Tuesday, investors asked for US$39.9 billion, more than half of the fund's assets, according to Crane Data.
The younger Bent told the fund's directors that he appealed by phone to the New York Fed for help securing financial support. He said he left a message with a receptionist.
Reserve's trustees instructed employees to sell the Lehman debt.
They couldn't find a buyer.
At 4pm, the trustees determined that the US$785 million investment was worth nothing. With all the withdrawals from the fund, the value of a single share dipped to US97c.
"They had Lehman and hot money - that's a bad combination," said Kevin Kennedy, a New York portfolio manager for money fund Western Asset Management.
Only one other fund had ever broken the buck - the much smaller Community Bankers Mutual Fund in Denver, which liquidated its US$82.2 million of assets in 1994.
"Bruce Bent told everybody he was safer than anybody else, but looking back he was the same as everybody else," said Mark Schild, president of Beech Hill Securities in Millburn, New Jersey, who had clients invested in the fund.
"Other funds would have broken the buck, but they all had big institutions to feed them money. Reserve didn't."
Legg Mason, Janus Capital Group, Northern Trust Corp, Evergreen and Bank of America's Columbia Management investment unit were all able to inject cash into their funds to shore up losses or buy assets from them.
At least 20 money fund managers were forced to seek financial support or sell holdings to maintain their US$1 net asset value.
Reserve Primary had no parent with deep pockets. While the Bents said they tried to sell the fund that week, they couldn't.
"It was like trying to measure wind speed in the middle of a hurricane when the speed is changing constantly - in all directions," Bruce Bent II said.
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.
It was already too late for Willard Scolnik, a 78-year-old retired architect in Palm Harbour, Florida.
Scolnik was visiting his son Stuart in Washington on September 16. 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 US$1.
He flipped open his phone and started dialling.
'BIG SHOCK'
Scolnik said his US$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."
While bank deposits were insured to US$100,000, money market funds were not insured at all.
By September 17, Scolnik still had not received his money.
Neither had Wal-Mart nor Goodyear Tire & Rubber, the biggest US tyremaker, which had US$360 million stuck in Reserve Primary.
With nowhere else to go, the Akron, Ohio, company tapped a revolving credit line, paying 5.93 per cent interest. The overnight rate for commercial paper issued by companies with Goodyear's credit status was 2.67 per cent on September 12.
That same day investors took US$78.7 billion out of money funds. By the end of the week, US$230 billion was gone from the US$3.6 trillion industry.
Also that Wednesday Paulson ordered senior adviser Steven Shafran to lead a team to devise a plan for stemming the run in the money markets. Shafran had worked at Goldman Sachs Group with Paulson, who was CEO of the firm before becoming Treasury Secretary in 2006. The team worked round the clock with the Fed to find a way to plug haemorrhaging funds. "And then we got on the phone again at 2 in the morning. We worked, went back and worked more. We wanted to flush the system with liquidity."
Scolnik returned to his home in Florida. He couldn't sleep.
He worried that David would die without his father to help him.
By late Thursday night, the Treasury and Fed were ready to stop the carnage. The next morning, September 19, the Government announced a temporary guarantee for money market funds, a US$50 billion insurance programme that backed all shares.
ECB FUNDING
The European Central Bank also stepped in to aid European banks left without a source of funding when the US commercial-paper market froze and the ice-nine spread across the Atlantic.
An average of 22 per cent of the commercial-paper holdings of the 15 largest US money funds last year were issued by European financial institutions.
On September 18, the ECB announced that it was prepared to increase funding in dollars to European banks to as much as US$110 billion, an amount later upped to US$240 billion.
The Fed created a special fund, the Commercial Paper Funding Facility, on October 7 to buy hard-to-sell short-term loans. Two weeks later it established the Money Market Investor Funding Facility to make loans of longer maturities.
"Industry assets might still be frozen today if the Treasury hadnot guaranteed all money funds and if the Fed had not provided a number of liquidity sources," Winters, the industry veteran, wrote in a July 23 letter to the SEC.
After two panics in two years, the SEC has proposed new rules to govern money markets.
The commission suggested a floating net asset value linked to market prices, instead of a stable US$1 NAV tied to the expected value of holdings when they mature. That way, share prices would drop as soon as a fund experienced a loss.
If a fund's value fell below US$1 to, say, US97c, clients who rushed to withdraw their money would get only 97 per cent of their investment, removing the incentive to withdraw quickly and preventing a run.
The Obama Administration has directed the President's Working Group on Financial Markets to consider the floating NAV and report back by December. 1.
The SEC recommended that funds hold a certain percentage of their assets in cash, so they can make payments in times of stress. Regulators also proposed upgrading the quality of the assets that funds can own and limiting them to securities with shorter maturity dates.
"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."
In addition to the SEC case, the Bents face at least 30 lawsuits from clients who claim they didn't live up to their promise to pay promptly and in full.
Wal-Mart, which got US$200 million back from Reserve Primary, is suing to recover its additional US$50 million.
Though his son David's health has deteriorated, Scolnik said he has not yet needed a lung transplant. Scolnik is suing to recover the US$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."
WHERE ARE THEY NOW?
The cast of the financial drama
DICK FULD
The last chief executive of Lehman Brothers has made one public appearance since that fateful weekend, telling a congressional hearing that the pain will stay with him for the rest of his life. Friends report he feels betrayed by Hank Paulson, and mystified by what he could have done differently, but he is now personally besieged by lawsuits from shareholders claiming he misled them.
KEN LEWIS
The Bank of America chief executive has lived to rue a whirlwind weekend of dealmaking - the acquisition of Merrill Lynch turned out to be pure poison. Spiralling losses forced Lewis to go cap in hand for a Government bailout, and shareholders revolted, stripping him of the additional title of chairman. His days at the helm are numbered.
HENRY PAULSON
The former Treasury Secretary had longed for retirement, a return to his loves of bird-watching and rearing wildlife on his farm in Illinois, but he has instead been fighting to salvage his reputation. Assailed by Congress, which believed he was more interested in helping his friends at Goldman Sachs than saving the real economy, he is writing a self-justificatory book, out in the New Year.
JOHN MACK
The Morgan Stanley chief kept his cool as panic threatened to engulf even his firm. He persuaded regulators to ban speculation against his shares and then became one of the first to pay back the Government bailout. Slated to retire next year.
JAMIE DIMON
This smooth son of Greek immigrants is now the King of Wall St. JPMorgan Chase absorbed not just Bear Stearns, but also the giant Washington Mutual. One of the few chief executives who pulled out of sub-prime in time, his cockiness is at new highs.
BEN BERNANKE
Obama prevaricated over reappointing the Republican academic to the Fed chairmanship, but an overwhelming number of economists advised that Bernanke - despite his mistakes - should be rewarded for preventing the crisis becoming, in his words, "Depression 2.0".
LLOYD BLANKFEIN
Proving that bankers can make money in any market, Goldman Sachs has soared back into the black this year, but Blankfein, its chief executive, has become a lightning rod for criticism of Wall St. He faces the tricky question of what to do about his bonus. He is on course to get a package worth US$50 million ($71 million) this year. Will he have the guts to take it?
TIMOTHY GEITHNER
With markets still in panic mode in January, Obama believed that promoting the New York Fed chairman to Paulson's old job would bring continuity. It almost backfired, when it was revealed Geithner had failed to pay US$35,000 in back taxes and his first bank rescue plan as Treasury secretary sent markets plunging. But he is growing in stature.
JOHN THAIN
The Merrill boss went from hero to zero in four months. He got US$50 billion from Bank of America, but his relationship with B of A's Ken Lewis was a disaster. Merrill's losses spiralled out of control and Lewis blamed Thain for keeping him in the dark. When Thain asked for a multimillion-dollar bonus, it was the last straw, and he was fired by Lewis in January in a 15-minute meeting.
- BLOOMBERG
