Professor/Lecturer Ellmann's Course Materials Page

economic thought
MBA/MA - Anglo-American University International Finance
ERASMUS - International Finance
MBA - Money and Financial Markets
ERASMUS Money & Banking
M.A. Public Policy Economic Sociology
On the Origin of Facts

Shock Forced Paulson's Hand

A Black Wednesday on Credit Markets; 'Heaven Help Us All'


When government officials surveyed the flailing American financial

system this week, they didn't see only a collapsed investment bank or

the surrender of a giant insurance firm. They saw the circulatory

system of the U.S. economy - credit markets - starting to fail.

Huddled in his office Wednesday with top advisers, Treasury Secretary

Henry Paulson watched his financial-data terminal with alarm as one

market after another began go haywire. Investors were fleeing

money-market mutual funds, long considered ultra-safe. The market

froze for the short-term loans that banks rely on to fund their

day-to-day business. Without such mechanisms, the economy would grind

to a halt. Companies would be unable to fund their daily operations.

Soon, consumers would panic.

For at least a month, Mr. Paulson and Treasury officials had discussed

the option of jump-starting markets by having the government absorb

the rotten assets - mainly financial instruments tied to subprime

mortgages - at the heart of the crisis. The concept, dubbed Balance

Sheet Relief, was seen at Treasury as a blunt instrument, something to

be used in only the direst of circumstances.

One day later, Mr. Paulson and Federal Reserve Chairman Ben Bernanke

sped to Congress to seek approval for the biggest government

intervention in financial markets since the 1930s. In a private

meeting with lawmakers, according to a person present, one asked what

would happen if the bill failed.

"If it doesn't pass, then heaven help us all," responded Mr. Paulson,

according to several people familiar with the matter.

Accounts of the events surrounding this week's unprecedented federal

interventions are based on interviews with Bush administration and

Congressional officials, as well as investors.

In the past two weeks, the relationship between government and the

markets has been redefined. The Bush administration has become

responsible for a major chunk of the U.S. housing market through its

seizure of mortgage giants Fannie Mae and Freddie Mac. It has entered

the insurance business in a big way after taking control of American

International Group Inc. Regulators allowed one investment bank to

fail and helped usher another into a fast merger. And on Friday, Mr.

Paulson announced plans for the largest intervention yet - a federal

plan to purge financial institutions of their bad assets, with a

likely price tag of "hundreds of billions" of dollars.

'Out of Control'

The panic had formed quickly. On Monday morning, Lehman Brothers

Holdings Inc. filed for bankruptcy protection. On Tuesday, the

government took control of AIG. It was by far the worst disruption

investors and policymakers had seen since the credit crisis gripped

world markets last summer, and threatened the most dire market

malfunction, some worried, since the crashes of 1929 and 1987. The

tailspin threatened to put an already stumbling economy deep into


"These markets are unhinged," T.J. Marta, fixed-income strategist at

RBC Capital Markets said Wednesday afternoon. "This is like a fire

that has burnt out of control."

For some assets, there were no buyers at any price. The weekend's

tumult set off a cascade of fear among investors who buy bonds of all

stripes, crucially those who buy the shortest-term obligations of

companies and financial institutions, called commercial paper. This

market feeds borrowers' most immediate needs for working capital.

Though U.S. authorities were alarmed, the situation they were facing

didn't yet resemble that of the 1930s. For one thing, easy credit from

the Fed had helped keep the economy afloat; in the early 1930s, the

Fed kept credit tight. "Nothing in the New Deal relies on monetary

policy the way we're relying on it today," said David Hamilton, a New

Deal historian at the University of Kentucky. Indeed, the Fed's

mistakes back then - in tightening, not loosening monetary policy -

are considered a key reason for the depth and severity of the

consequent depression.

[U.S. Treasury Secretary Henry Paulson] Reuters

Treasury Secretary Paulson pauses as he speaks about the U.S.

government plan to attack financial market weakness by buying up risky

loans at a news conference at the Treasury Department in Washington on


The current turmoil is also more contained, noted Colin Gordon, a

professor of 20th-century American history at the University of Iowa.

"At least for the moment...the crisis is confined to the large New

York houses," he said. "You don't have panic on Wall Street resulting

in banks closing in Iowa City."

On Monday and Tuesday, nonetheless, many investors were gripped by

fear. Markets such as those for credit-default swaps - in which

investors buy and sell protection against default on a borrower's debt

- were paralyzed by questions about how the Lehman bankruptcy would

hurt their business. Stock investors pummeled the share prices of

Morgan Stanley and Goldman Sachs Group Inc., the two remaining big

stand-alone Wall Street investment firms. Participants in the

credit-default-swap market, who need a trading partner for every

transaction, didn't know whom to trust.

Flooding to Treasurys

"The market was signaling that the stand-alone investment banking

model doesn't work," says Tad Rivelle, chief investment officer at

Metropolitan West Asset Management, which manages $26 billion in

fixed-income assets. "We were on the verge of putting every Wall

Street firm out of business."

Instead, investors flooded the safest investment they could find,

short-term government debt. This drove the yields of short-term

Treasury bonds to zero, meaning investors were willing to accept no

return on their investment if they could guarantee getting their money


On Tuesday, the once-$62.6 billion Reserve Primary Fund, a

money-market fund, saw its value fall below $1 a share because of its

investments in Lehman's short-term debt. Money-market funds, which

yield a bit more than basic cash accounts by buying safe, short-term

debt instruments, strive to keep their share prices at exactly $1 -

and "breaking the buck" isn't supposed to happen.

Money-market funds are where corporate treasurers put rainy-day funds,

where sovereign wealth funds park their excess dollars and where

Mom-and-Pop investors stash savings. Now, money-market funds were

selling what they could and hoarding cash to meet what they thought

might be extraordinary levels of redemptions from investors, said one

commercial trading desk head.

Treating the Symptoms

On a Tuesday conference call, staff from Treasury, the Federal Reserve

and Federal Reserve Bank of New York hashed out the plan to bail out

AIG. But they also began to discuss what more could be done to stem

the broader fallout. Some Fed officials saw the AIG takeover not as a

potential turning point for the market - as the rescue of Bear

Stearns Cos. had seemed to be in March - but as the beginning of a

bigger and worsening problem.

"We're treating the symptoms and we need to treat the cause," one

Treasury staffer told colleagues.

Mr. Paulson agreed. "Confidence is so low we're going to need a fiscal

response," he told staff. In other words, the government's usual

monetary policy tools, such as interest rates, wouldn't be enough. It

would have to pony up some money.

Wild Week

Listen to a Wall Street Journal Radio report on the financial sector's

wild week.

Mr. Paulson spoke with Mr. Bernanke and Federal Reserve Bank of New

York President Timothy Geithner to discuss a systematic approach. The

three agreed that buying distressed assets, such as residential and

commercial mortgages and mortgage-backed securities, from financial

companies could offer some relief.

Trust in financial institutions evaporated Wednesday when investors

stampeded out of money-market funds. Putnam Prime Money Market Fund

said it had shut down after a surge of requests for redemptions.

In three days, the Fed had pumped hundreds of billions of additional

cash into the financial system. But instead of calming markets and

helping to suppress interest rates, short-term interest rates had gone

haywire. Most strikingly to some Fed staff, its own federal-funds

rate, an interbank lending rate managed directly by the central bank,

repeatedly shot up in the morning as banks sat on cash. The financial

system was behaving like a patient losing blood pressure.

Bracing for Redemptions

Fed staff discovered that one reason the federal-funds rate was

behaving so abnormally was because money-market funds were building up

cash in preparation for redemptions, leaving hoards of cash at their

banks that the banks wouldn't invest.

U.S. depositary institutions on average held excess reserves of $90

billion each day this week, estimates Lou Crandall, chief economist at

Wrightson ICAP. This is cash the banks hold on the sidelines that does

not earn any interest. That compares with an average of $2 billion, he

says, noting he estimates banks held $190 billion in excess cash on

Thursday, as they feared they'd have to meet many obligations at the

same time.

Through Wednesday, money-market fund investors - including

institutional investors such as corporate treasurers, pension funds

and sovereign wealth funds - pulled out a record $144.5 billion,

according to AMG Data Services. The industry had $7.1 billion in

redemptions the week before.

Without these funds' participation, the $1.7 trillion commercial-paper

market, which finances automakers' lending arms or banks credit-card

units, faced higher costs. The commercial-paper market shrank by $52.1

billion in the week ended Wednesday, according to data from the

Federal Reserve, the largest weekly decline since December.

Without commercial paper, "factories would have to shut down, people

would lose their jobs and there would be an effect on the real

economy," says Paul Schott Stevens, president of the Investment

Company Institute mutual-fund trade group.

Officials also watched as the market for mortgage-backed securities

disappeared. The government's seizure of Fannie Mae and Freddie Mac,

they had hoped, would reinstill confidence in this market. But yields

on mortgage-backed bonds were rising as trading evaporated, nearing

levels reached before the government's takeover, which would likely

translate into higher mortgage rates for consumers. Borrowers with

adjustable-rate mortgages, meanwhile, were in trouble: The cost of

many such loans is based on Libor, or the London interbank offered

rate, which had soared as banks stopped lending to one another.

On Wednesday in Mr. Paulson's office, with its photographs of birds

and other wildlife taken during family trips, top advisers stayed

close at hand. Watching market quotes, they participated in an ongoing

conference call via speakerphone with the Federal Reserve and New York


Root of the Problem

Mr. Paulson wanted Congress to bless a plan that would allow Treasury

to create a new facility to hold auctions and buy up distressed assets

from financial institutions headquartered in the U.S. Without

Congressional approval, Treasury could expand programs to buy

mortgage-backed securities through Fannie Mae and Freddie Mac, but

that wouldn't be enough to address the broadening problems.

The Fed, meanwhile, was supposed to be a lender of last resort to

banks. It wasn't built to fix all these problems, and the snowballing

crisis worried Fed officials.

"This financial episode is one where a huge part of the problem is

outside of the banking system," said Frederic Mishkin, a Columbia

University professor who recently left the Federal Reserve as a

governor. "We're in a whole new ball game."

On Thursday, Messrs. Paulson and Bernanke decided to ask Congress for

authority to buy up hundreds of billions of dollars of assets. In the

afternoon, Mr. Paulson, Mr. Bernanke and Securities and Exchange

Commission Chairman Christopher Cox briefed President Bush for 45


Mr. Paulson told Mr. Bush that markets were frozen and many different

types of assets had become illiquid, or untradeable. Messrs. Paulson

and Bernanke told the president that the situation was

"extraordinarily serious," according to a senior administration


"We need to do what it takes to solve this problem," Mr. Bush replied.

That evening, during the meeting with Congressional leaders, Mr.

Bernanke gave a "chilling" description of current conditions,

according to one person present. He described the frozen credit

markets, busted commercial-paper markets and attacks on investment

banks. The financial condition of some major institutions was

"uncertain," he said.

'Uncertain Fate'

"If we don't do this, we risk an uncertain fate," Mr. Bernanke added.

He said that if the problem wasn't corrected, the U.S. economy could

enter a deep, multi-year recession akin to Japan's lost decade of the

1990s, or what Sweden endured in the early 1990s when a surge in bad

loans plagued the economy and sent unemployment to 12%.

One lawmaker asked whether the solution will prevent bank failures.

Mr. Paulson said it will stabilize markets. "But we'll still see banks

fail in the normal course," he said.

On Friday, Mr. Paulson announced plans for a sweeping program to take

over troubled mortgage assets. "The federal government must implement

a program to remove these illiquid assets that are weighing down our

financial institutions and threatening our economy," he said at a

press conference. He said he would work with Congress over the weekend

to get legislation in place next week.

During a round of briefings on Friday, Messrs. Bernanke and Paulson

chilled lawmakers with their dire warnings about the cost of inaction.

They had already taken additional steps, including new measures to

unfreeze money-market mutual funds and an SEC plan to temporarily ban


Speaking that afternoon, House Financial Services Chairman Barney

Frank, the Massachusetts Democrat, tagged the rescue of AIG as the

tipping point. "It didn't have the broader calming effect," Rep. Frank

said. "They tried it the free-market way, they tried it the big

intervention way - and the result was on Wednesday, the world was

falling in on everybody's ears."

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