Shock Forced Paulson's Hand
A Black Wednesday on Credit Markets; 'Heaven Help Us All'
By DEBORAH SOLOMON, LIZ RAPPAPORT, DAMIAN PALETTA and JON HILSENRATH
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
[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.
Listen to a Wall Street Journal Radio report on the financial sector's
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
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.
"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."