The extent of
the credit crisis that unfolded from the morning of Sept. 17
to the afternoon of Sept. 18. was unseen to the public but
spooked policy makers into action.
can cause a prudent person to do rational things that can contribute to the
failure of an institution.” — William A. Ackman of the hedge fund
Pershing Square Capital Management.
It was early on Wednesday,
Sept. 17, when executives at Pershing Square, Bill Ackman’s hedge fund,
began getting nervous calls and e-mail messages from investors. Mr. Ackman,
42, has been a top Wall Street player for 15 years, making his clients — and
himself — billions of dollars.
But now, Mr. Ackman and his
colleagues were taken aback by what they were hearing. His big investors
were worried about all of the Pershing assets held by
Goldman Sachs, the blue-chip investment bank, whose stock had come under
Never mind that Goldman kept
Pershing’s assets in a segregated account, and that the money was safe. And
never mind that Mr. Ackman believed Goldman was the world’s best-run
investment bank and would come through the
credit crisis unscathed.
Pershing investors still
feared their money might be exposed. Mr. Ackman advised Goldman executives
to do something to restore confidence — such as getting an infusion of
Warren E. Buffett, the billionaire investor. And while Mr. Ackman kept
his assets at Goldman, he hurriedly set up accounts at three other
institutions — just in case things got much worse.
Pershing had more faith than
most. Up and down Wall Street, hedge funds with billions of dollars at
Morgan Stanley, another storied investment bank, were frantically
pulling money out and looking for safer havens.
Panic was spreading on two
of the scariest days ever in financial markets, and the biggest investors —
not small investors — were panicking the most. Nobody was sure how much
damage it would cause before it ended.
This is what a credit crisis
looks like. It’s not like a stock market crisis, where the scary plunge of
stocks is obvious to all. The credit crisis has played out in places most
people can’t see. It’s banks refusing to lend to other banks — even though
that is one of the most essential functions of the banking system. It’s a
loss of confidence in seemingly healthy institutions like Morgan Stanley and
Goldman — both of which reported profits even as the pressure was mounting.
It is panicked hedge funds pulling out cash. It is frightened investors
protecting themselves by buying
credit-default swaps — a financial insurance policy against potential
bankruptcy — at prices 30 times what they normally would pay.
It was this 36-hour period
two weeks ago — from the morning of Wednesday, Sept. 17, to the afternoon of
Thursday, Sept. 18 — that spooked policy makers by opening fissures in the
worldwide financial system.
In their rush to do
something, and do it fast, the
Federal Reserve chairman,
Ben S. Bernanke, and Treasury Secretary
Henry M. Paulson Jr. concluded the time had come to use the “break the
rescue plan they had been developing. But in their urgency, they
bypassed a crucial step in Washington and fashioned their $700 billion
bailout without political spadework, which led to a resounding rejection
this past Monday in the House of Representatives.
That Thursday evening,
however, time was of the essence. In a hastily convened meeting in the
conference room of the House speaker,
Nancy Pelosi, the two men presented, in the starkest terms imaginable,
the outline of the $700 billion plan to Congressional leaders. “If we don’t
do this,” Mr. Bernanke said, according to several participants, “we may not
have an economy on Monday.”
Setting the Stage
Wall Street executives and
federal officials had known since the previous weekend that it was likely to
be a difficult week.
With the government refusing
to offer the same financial guarantees that helped save
Fannie Mae and
Freddie Mac, efforts on Saturday to find a buyer for
Lehman Brothers had failed.
Sunday was spent preparing
to deal with Lehman’s bankruptcy, which was announced Monday morning.
Merrill Lynch, fearing it would be next, had agreed to be bought by
Bank of America. The
American International Group was near collapse. (It would be rescued
with an $85 billion loan from the Federal Reserve on Tuesday evening.)
With government policy
makers appearing to careen from crisis to crisis, the Dow Jones industrial
average plunged 504 points on Monday, Sept. 15. Panic was in the air.
At those weekend meetings,
Wall Street executives and federal officials talked about the possibility of
contagion — that the Lehman bankruptcy might set off so much fear among
investors that the market “would pivot to the next weakest firm in the
herd,” as one federal official put it.
That firm, everyone knew,
was likely to be Morgan Stanley, whose stock had been dropping since the
previous Monday, Sept. 8. Within three hours on Tuesday, Sept. 16, Morgan
Stanley shares fell another 28 percent, and the rising cost of its
credit-default swaps suggested investors were predicting bankruptcy.
To allay the panic, the firm
decided to report earnings a day early — after the market closed Tuesday
afternoon instead of Wednesday morning. The profit was terrific — $1.425
billion, just a 3 percent decline from 2007 — and the thinking was that
would give investors the night to absorb the good news.
“I am hoping that this will
generally help calm the market,” Morgan Stanley’s chief financial officer,
Colm A. Kelleher, said in an interview late that afternoon. “These markets
are behaving irrationally. There’s a lot of fear.”
The Spreading Contagion
But contagion was already
spreading. The problem posed by the Lehman bankruptcy was not the losses
suffered by hedge funds and other investors who traded stocks or bonds with
the firms. As federal officials had predicted, that turned out to be
manageable. (That was one reason the government did not step in to save the
The real problem was that a
handful of hedge funds that used the firm’s London office to handle their
trades had billions of dollars in balances frozen in the bankruptcy.
Management, for instance, a $3 billion hedge fund, told its investors that
14.9 percent of its assets were locked up in the Lehman bankruptcy — money
it could not extract. A number of other hedge funds were in the same
predicament. (When called for comment, Diamondback officials did not
As this news spread, every
other hedge fund manager had to worry about whether the balances they had at
other Wall Street firms might suffer a similar fate. And Morgan Stanley and
Goldman Sachs were the two biggest firms left that served this back-office
role. That is why Mr. Ackman’s investors were calling him. And that is what
caused hedge funds to pull money out of Morgan Stanley and Goldman Sachs,
hedge their exposure by buying credit-default swaps that would cover losses
if either firm couldn’t pay money they owed — or do both.
It was fear, not greed, that
was driving everyone’s actions.
Breaking the Buck
There was another piece of
bad news spooking investors — and government officials. On Tuesday, the
Reserve Primary Fund, a $64 billion money market fund, and two smaller,
related funds, revealed that they had “broken the buck” and would pay
investors no more than 97 cents on the dollar.
Money market funds serve a
critical role in greasing the wheels of commerce. They use investors’ money
to make short-term loans, known as commercial paper, to big corporations
Microsoft. Commercial paper is attractive to money market funds because
it pays them a higher interest rate than, say,
United States Treasury bills, but is still considered relatively safe.
A run on money funds could
force fund managers to shy away from commercial paper, fearing the loans
were no longer safe. One reason given by the Reserve Primary Fund for
breaking the buck was that it had bought Lehman commercial paper with a face
value of $785 million that was now worth little because of its bankruptcy.
If money market funds became fearful of buying commercial paper, that would
make it far more difficult for companies to raise the cash needed to pay
employees, for instance. At that point, it would not just be the credit
markets that were frozen, but commerce itself.
Just as important, in the
eyes of federal officials, was that money market funds had long been viewed
by investors as akin to bank accounts — a safe place to store cash and earn
interest on that money. Despite lacking federal deposit insurance, these
funds held $3.4 trillion in assets.
“Breaking the buck was the
Rubicon,” said a federal official. “This was the first time in the crisis
that you could see stories talking about how it was affecting real people.”
Since that Monday, big
institutional investors — like pension funds and college endowments — had
been pulling money out of money funds. On Tuesday, individual investors
joined the stampede.
Investment Company Institute, the trade group for the mutual fund
industry, executives had organized a conference call that week with
top-level fund executives and government officials.
“We were saying to Treasury
and the Fed, at a very high level: Pay attention to this issue. This will
have an impact,” recalled Greg Ahern, the group’s chief communication
But government officials
monitoring the crisis did not need the warning. They were already watching
money fund outflows with alarm.
investors — feeling better because of the government’s A.I.G. rescue plan —
either did not comprehend or ignored the growing chaos in credit markets;
the Dow actually rose 141.51 points on Tuesday.
A Dark Day
The respite was brief.
Wednesday, Sept. 17, was one of those dark, ugly market days that offers not
even a glimmer of hope.
Fearing the worst, Alex
Ehrlich, the global head of prime services at the Swiss bank
UBS, arrived at work in New York at 5 a.m. and immediately started
putting out fires. Because he ran the firm’s prime brokerage unit, clients
were calling to see whether their money was safe.
“We were being flooded with
client requests to move positions, and the funding markets, which are
critically important to prime brokers, were extremely volatile,” he said.
Within seconds of the market
opening, the Dow was down 160 points. Among the big losers was Morgan
Stanley. Despite the strong earnings it had disclosed late Tuesday, its
stock continued to plummet. By noon, the Dow was down 330 points. It rallied
in the afternoon, but went into free fall in the last 45 minutes, closing
down 449 points.
And that was just what
investors could see. Behind the scenes, the credit markets had almost
completely frozen up. Banks were refusing to lend to other banks, and
spreads on credit default swaps on financial stocks — the price of insuring
against bankruptcy — veered into uncharted waters.
Moreover, the drain on money
funds continued. By the end of business on Wednesday, institutional
investors had withdrawn more than $290 billion from money market funds. In
what experts call a “flight to safety,” investors were taking money out of
stocks and bonds and even money market funds and buying the safest
investments in the world: Treasury bills. As a result, yields on short-term
Treasury bills dropped close to zero. That was almost unheard of.
In the stock market, Mr.
Ehrlich of UBS was horrified by the plunge of Morgan Stanley’s shares, given
the stellar earnings. “It felt like there was no ground beneath your feet,”
he said. “I didn’t know where it was going to end.”
A Chief Executive’s Anger
Neither did Morgan Stanley’s
John J. Mack. A week before, his firm’s stock was trading in the
mid-40s. On Wednesday, it fell from $28.70 a share to $21.75 — down about 50
percent over a week.
“There is no rational basis
for the movements in our stock or credit default spreads,” Mr. Mack wrote in
a companywide memo on Wednesday. Mr. Mack lashed out at the people he felt
were responsible for Morgan Stanley’s woes: the short-sellers, who profit by
betting that a stock will fall.
Like most Wall Street firms,
Morgan Stanley over the years had handled transactions for short-sellers,
despite complaints by other companies that short-sellers unfairly ganged up
on their stock. Nevertheless, Mr. Mack called Senator
Charles E. Schumer, Democrat of New York, and
Christopher Cox, the chairman of the Securities and Exchange Commission,
pressing them to ban short-selling.
He raged about what he
viewed as a concerted effort to drive down the firm’s stock. “He got
emotional,” says one person who knows him well.
Meeting with staff members
Thursday morning as the stock plunged further — hitting a low of $11.70
midday — Mr. Mack said: “Listen. I know everybody is anxious about the stock
price. I’m not selling any shares, and neither is my team. But I understand
if you’re nervous and want to sell some shares.” Some did. (The company said
fewer than one-third of employees sold stock that day.)
At the same time, Mr. Mack
began talks to merge with
Wachovia, and called other banks about possible combinations. He also
called Mr. Buffett for advice, while aides in Tokyo contacted Mitsubishi UFJ,
Japan’s biggest lender, hoping to raise additional capital.
Run on a Fund
Even as stocks tanked,
turmoil was worsening in money markets. On Wednesday evening, Paul Schott
Stevens, the head of the Investment Company Institute, learned about a
problem with another money fund. “This time it was Putnam,” recalled Mr.
Stevens, referring to the Boston-based mutual fund company
Out of the blue, it seemed,
there was a run on the $12.3 billion Putnam Prime Money Market Fund. That
meant the money fund contagion was spreading. Because of huge withdrawals,
Putnam decided it had to shut the fund, and distribute the cash to
shareholders. If it did not, the first ones out the door would get a better
deal than the laggards.
Executives of the Investment
Company Institute and fund officials scrambled to find a solution that would
keep Putnam from having to take that step, but they failed. On Thursday,
Putnam shuttered the fund. (After the government rescue plan was announced,
it sold the fund, intact, to another company, and investors did not lose a
The Fed Takes Action
Ben Bernanke had spent his
career studying financial crises. His first important work as an economist
had been a study of the events that led to
the Great Depression. Along with several economists, he came up with a
phrase, “the financial accelerator,” which described how deteriorating
market conditions could speed until they became unmanageable.
To an alarming degree, the
credit crisis had played out as his academic work predicted. But his
research also led Mr. Bernanke to the view that “situations where crises
have really spiraled out of control are where the central bank has been on
the sideline,” according to Mark Gertler, a
New York University economist who has collaborated with Mr. Bernanke on
Mr. Bernanke had no
intention of keeping the Fed on the sidelines. As the crisis deepened, it
took more aggressive steps. It added liquidity to the system. It opened the
discount window — the emergency lending facility that had been reserved for
troubled banks — to investment banks. It also agreed to absorb up to $29
billion in Bear Stearns losses and made an $85 billion loan to keep A.I.G.
Barney Frank, the Massachusetts Democrat who leads the House Financial
Services Committee, asked Mr. Bernanke if the Fed had $85 billion to spare.
“We have $800 billion,” Mr. Bernanke replied, according to Mr. Frank.
Since the Bear Stearns
bailout, Treasury and Fed officials had discussed what a broad government
intervention might look like. Although there were suggestions for a “bank
holiday” — a temporary, nationwide closing of banks, which had not been done
since 1933, to stem panicky withdrawals — Mr. Bernanke and Mr. Paulson
dismissed the idea, fearing it would do far more harm than good by scaring
people needlessly. They had both assembled teams to map out drastic rescue
plans — the “break the glass” plans.
Almost from the start, they
concluded the best systemic solution was to buy hard-to-sell mortgage-backed
On Wednesday morning, during
a conference call with other top officials, including
Jean-Claude Trichet, the president of the
European Central Bank, Mr. Bernanke sounded them out on a big government
bailout. The other officials sounded relieved; their main questions were
about whether Congress could act quickly.
That evening, Mr. Bernanke
told Mr. Paulson during a conference call: “You have to go to Congress. This
is pervasive.” Mr. Paulson agreed.
A Sense of Urgency
By Thursday morning, the
need for dramatic action had grown even more urgent.
In Asia, stocks had already
closed lower. To quell fears before the opening of European markets, the Fed
and other central banks announced they would make $180 billion available, in
an effort to get banks to start lending to each other again. The Fed had
agreed to open its discount window to make loans available to money market
funds to prevent further runs.
But it was to little avail.
At 8:30 Thursday morning in
the United States, when Mr. Paulson and Mr. Bernanke reviewed the state of
affairs, markets remained roiled. The crisis was not easing up.
One Bank’s Solution
Lloyd C. Blankfein, Goldman Sachs’s chief executive, had arrived at the
firm’s office on 85 Broad Street just before 7 a.m. Thursday, anticipating
another bad day. The investment bank’s stock had already been pummeled. From
nearly $250 a share last October, it had fallen to $114.50 on Wednesday —
after hitting a low of $97.78 that day.
One idea he had been
exploring was to transform Goldman into a bank holding company. Mr. Mack,
meantime, was also considering such a move for Morgan Stanley, and both were
in separate discussions with the Fed. There was safety in that notion — they
would become depository institutions regulated by the Fed and others —
though it also meant they would not be able to pile on as much debt as they
had as investment banks. That would hurt profits. But now profits were less
pressing than survival. Mr. Blankfein accelerated the planning.
By 1 p.m., the Dow had
fallen another 150 points — meaning that in a day and a half it was down
nearly 600 points. Goldman’s stock dropped to $85.88, its lowest in nearly
Just then, a prankster piped
“The Star-Spangled Banner” over the firm’s loudspeaker system on the 50th
floor. Fixed-income traders stopped and stood at attention, some with hands
on their hearts. Oddly, it was at precisely that moment that the market —
and Goldman’s shares — started to rise.
The traders began to cheer.
What happened? At 1 p.m. New
York time, the Financial Services Authority in Britain, which regulates that
nation’s financial institutions, announced a ban on short-selling of 29
financial stocks that would last at least 30 days.
“When I saw that, I knew we
were about to have the mother of all short squeezes,” said one hedge fund
manager. Realizing that the S.E.C. was likely to follow suit, hedge funds
began “covering their shorts” — that is, buying the stocks they had borrowed
to short, even if it meant taking a loss.
That caused all kinds of
stocks to begin rising. Sure enough, the S.E.C. followed suit the next day,
placing a temporary short-selling ban on 799 financial stocks.
A few hours later came the
second event. At 3:01 CNBC reported the Treasury and the Fed were planning a
giant fund to buy toxic mortgage-backed assets from financial institutions.
Though there had been hints of this earlier in the afternoon, and stocks had
started rising around 2:30, the wide dissemination set off a huge rally. In
a 45-minute burst, the Dow gained another 300 points, closing the day up 410
Meeting on Capitol Hill
Two hours later, Mr. Paulson
and Mr. Bernanke trooped up to Capitol Hill for a somber session with
Congressional leaders. “That meeting was one of the most astounding
experiences I’ve had in my 34 years in politics,” Senator Schumer recalled.
As the members of Congress
and their aides listened, the two laid out their plan. They would begin
offering federal insurance to money market funds immediately, in order to
stop the run on money funds.
In addition, the S.E.C.
would institute a ban on short-selling of financial stocks. Although
Treasury officials concede that the move was mostly symbolic — investors can
still buy put options that have the same effect as shorting stocks — they
did it mainly “to scare the hell out of everybody,” as one official put it.
After Mr. Bernanke made his
remark about the possibility that there might not be an economy on Monday
without this plan, you could hear a pin drop.
“I gulped,” Mr. Schumer
Congressional leaders were
nearly unanimous in saying that it needed to be done for the good of the
John A. Boehner of Ohio — the Republican House leader who a week later
would lead the revolt against the plan — said it was time to put politics
aside and move quickly, according to several participants. (An aide to Mr.
Boehner denied that he voiced support for the plan, only that he made a plea
Hearing that Mr. Bernanke
and Mr. Paulson wanted legislation passed in a matter of days, the Senate
Harry Reid, expressed astonishment. “This is the
United States Senate,” he said. “We can’t do it in that time frame.” His
Republican counterpart, Senator
Mitch McConnell, replied, “This time we can.”
He was wrong. After a week
of wrangling, political infighting and compromise, the House on Monday voted
down the legislation. The Dow plunged nearly 778 points, and credit markets
had worsened, with interest rates rising and loans becoming harder to
Two weeks after Mr. Paulson
and Mr. Bernanke made their appeal, the House is likely to try again.
Additional reporting was by
Jenny Anderson, Nelson D. Schwartz, Eric Dash, Louise Story, Michael M.
Grynbaum, Carter Dougherty and Vikas Bajaj.