The following is an excellent excerpt from the book “THE END OF WALL STREET” by Roger Lowenstein from Chapter 14 titled “Aftershocks” on page 202 and I quote:
“If we have learned anything throughout this year, we have learned that this financial crisis is unpredictable and difficult to counteract.” –Hank Paulson, November 18 Op-Ed, New York Times
“Lehman’s bankruptcy, the biggest in U.S. history, overwhelmed markets. The direct hit to creditors, from whom Lehman had borrowed $600 billion, reverberated around the world. Investors as diverse as Norway’s state pension fund and the State of New Jersey were suddenly staring at worthless paper. The disruption was immediate. By Monday morning, investors were calling the New York Fed in a panic, reporting that no one at Lehman was picking up the phone.
The psychological blow of seeing a major bank disintegrate was profound. The comforting precedent set by Bear Stearns and reinforced by Fannie and Freddie—that creditors would be protected—was demolished in a stroke. If [Hank] Paulson had wanted to demonstrate that investors bore a hazard, he succeeded beyond his wildest dreams. Credits of banks—all banks—now were judged at risk. As lenders bolted, borrowing costs for banks soared. And as rates rose, industrial companies drew down bank loans to be assured of funds, reducing what was left of banks’ already dwindling liquidity.
Yields of T-bills collapsed as well, as money was rechanneled toward the government, seen as the only safe haven. The Friday before the Lehman filing, the interest rate of thirty-day bills had been a paltry 1.3 percent; on Monday, it crashed to 0.22 percent. Investors were not “investing” in bills; they were using the government as a store of safekeeping; even a microscopic return was judged to be better than the risk of loss that tainted every private investment. Wall Street for so long had been characterized by boldness; now extreme caution was the watchword. Lehman’s collapse had lowered the curtain not just on a historic, scrappy firm but on an era. [Richard] Fuld, like an exiled autocrat, sent a forlorn note to the staff: “I know that this has been very painful for you, both personally and financially. For this, I feel horrible.”
The Fed immediately took the place of Lehman’s “repo” lenders, in hopes of letting the bankrupt firm wind down in orderly fashion. Its loans over the next few days totaled $46 billion, all backed by collateral. At the same time, Barclays continued to negotiate with Lehman’s estate in the hopes of purchasing the carcass out of bankruptcy.
However, while the U.S. subsidiary was temporarily shielded by the Fed, Lehman ceased to exist as an integrated firm, and this wreaked unexpected havoc. Money flows between its subsidiaries were suspended, and Lehman’s London branch, occupied by scores of accountants and lawyers, was virtually shut down. UK bankruptcy practices did not, reliably, segregate corporate from customer accounts; as a result, monies of hedge fund clients from the United States and elsewhere were frozen by British law. This triggered a ruinous stampede. Some seven hundred hedge funds awoke on Monday and learned that a portion of their assets were trapped. [Footnote: Hedge fund groups with money frozen in Lehman included Amber Capital, Autonomy Capital Research, By Harbour Management, D.E. Shaw, GLG Partners, Harbinger Capital Partners, and Och-Ziff Capital Management.]
The hedge fund industry, whose capitalization was $2 trillion, retaliated by purchasing credit default swaps, in particular on Morgan Stanley and Goldman—the only investment banks that remained in independent form. Some were acting defensively, merely purchasing insurance; others were making outright (and hostile) speculations. No matter, the effect was the same. Premiums soared, unnerving the two firms long considered the class of Wall Street.
Rising CDS rates triggered huge losses for firms that had sold insurance. They were hit with demands for margin money, estimated for Monday alone at well over $100 billion. The viral effects were incalculable. Stocks plunged, the Dow losing 524 points, its worst fall since 9/11. As with the various parts of Lehman, the larger financial community began to disintegrate. Investors trimmed portfolios, traders withdrew, especially from credit markets, and financial flows quieted, as if a gurgling brook had turned deathly still.
Lehman had a million and a half derivative contracts, with thousands of different counterparties, and the prospect of unwinding them horrified the Fed. As formidable as the derivatives seemed, they proved less troublesome than a single investment that, in the chaos of the previous weekend, the government had overlooked.
Aside from Treasury securities and government-insured bank deposits, money market mutual funds have long been considered the safest haven on Wall Street. They were the brainchild of a single creator, Bruce Bent, who in 1972 opened a fund to invest in a diversified group of short-term credit instruments. He offered investors a higher return than on savings accounts with seeming safety and instant liquidity. Indeed, the attraction of the money market industry was its reputation for total preservation of capital, pegged at $1 a share. Reserve Management, Bent’s firm, swore an oath to maintaining net asset value, boasting in its literature, ‘The Reserve is committed to a $1.00 NAV.”
Bent was something of a prophet, warning the industry, as it grew, against the dangers of reaching for higher yield by stooping to inferior credits. In particular, he denounced commercial paper as overly risky. After the rash of near-failures in 2007, when money funds were infected by SIVs, Bent held forth on the particular risks of mortgage-backed securities, and on the foolhardiness of those who traded in them. But he did not live up to his rules. Reserve’s Primary Fund, its flagship, had since then been stocking up on commercial paper—including $785 million issued by Lehman Brothers. All the while, Bent continued making high-minded pronouncements, commenting in July: “Wall Street—they don’t have any brains—all they do is market.”
Monday morning, investors in the Primary Fund awoke to the fact that 1.2 percent of their assets were invested in Lehman (a fact that had been posted on the funds’ Web site). Some of its investors were individuals but most were institutions, including Fortune 500 corporations such as Time Warner and public entities such as school districts, who parked their cash with Primary to earn a slightly higher yield, under the premise that it remained risk-free.
Sensing that the first to redeem would be the most likely to get out whole, these investors ran for the doors; soon, the rest of Wall Street followed. At 7:51 A.M., Reserve received a redemption order for $56 million. One minute later, another, larger, redemption arrived. By 8:30 A.M., twenty-two investors, mostly institutional, had redeemed $5 billion of their money—or at least, they had submitted orders for same. The rout was on.
The fund trustees hastily conferred (Bent, who had flown to Italy the previous day to celebrate his fiftieth wedding anniversary, participated by phone) and decided to value Lehman’s paper at eighty cents on the dollar, maintaining the hope that losses on Lehman would be modest. Sales personnel were instructed to tell callers that even this twenty-cent loss was inconsequential, only temporary, as Lehman’s paper would eventually be redeemed at par. Callers were told, further, that if any loss was sustained, the Reserve company would cover the difference. As the tide of redemptions swelled, State Street, the independent custodian that oversaw the fund, halted payments. Fund employees assured investors that it was not suffering liquidity issues, merely processing delays, and urged investors not to redeem. Meanwhile, Reserve frantically sought help from the Fed.
Though Lehman was a big issuer of commercial paper, in all of the regulators’ preparations no one had considered its likely impact on money market funds. This is less a criticism of the regulators than of the conceit that officials can ever foresee every significant aftershock. Market earthquakes, like those in nature, produce unexpected fissures and seemingly random jolts. From the [Alan] Greenspan era on, official policy had been predicated on Washington’s ability to manufacture soft landings when market excesses led to busts. But mortgage speculation had been so extreme, it is doubtful that any virtuosos in the treasury and the Fed could have avoided a crash landing.
Paulson doggedly defended his actions—or rather, nonactions—on Lehman. Briefing reporters at the White House on Monday, he all but boasted, “I don’t ever take lightly putting the taxpayer on the line to support an institution.” This sentiment was praiseworthy, but it was in conflict with what Paulson uttered at the same gathering , that “nothing is more important right now than the stability of our capital markets.” {Footnote: Paulson’s press conference comment, “I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers,” has the mark of an off-the-cuff declaration rather than the literal truth. When asked why Lehman had not received help, as had Bear, he said the situation and facts were “very different” ; he did not specify the differences. [Ben] Bernanke gave a fuller explanation the following week, when he declared in Congress, “In the case of Lehman Brothers. . . we judged that investors and counterparties had had time to take precautionary measures.” Neither official alluded to the explanation subsequently, and vehemently, offered, that Lehman’s collateral was insufficient to support a loan. This became the standard response only after the crisis deepened.]”
(YOU CAN EASY SEE THE BIG HEDGE FUND DEALERS PANICING WHEN THEY COULDN’T FIGURE OUT WHAT WAS HAPPENING OVER IN ENGLAND BECAUSE THEY HADN’T LOOKED THAT FAR AHEAD, PARTICULARLY INVOLVING TWO AMERICAN HEDGE FUNDS SELLING DERIVATIVES, GOLDMAN SACHS AND MORGAN STANLEY. NOW, SINCE THERE WASN’T ENOUGH MONEY TO COVER ALL THEIR LOSSES, EVEN THOUGH, THEY, THEMSELVES, WERE GOING TO AIG FOR HELP, THAT WASN’T A SOLUTION EITHER BECAUSE THEY TOO, WERE KNEE DEEP IN DERIVATIVES. YOU CAN EASY SEE WHY THEY ARE GOING TO HAVE TO COME TO THE AMERICAN TAXPAYER TO BAIL OUT FREE ENTERPRISE, WHICH THE GOVERNMENT DID AT LEAST ONCE AFTER THE 2008 DISASTER AND MAYBE MORE. YOU’D THINK, AFTER THE PROBLEM THE WORTHLESS, TOXIC DERIVATIVES GOT THEM INTO THAT THE HEDGE FUNDS SELLING THEM WOULD GRADUALLY BACK OFF AND TRY ACCURATELY PROMOTING REAL COMMODITIES AND CURRENCIES. NOT FAKE ONES BUT NO SUCH THING EVER HAPPENED. IN FACT, THE LATEST BLOOMBERG BUSINESSWEEK OF MAY 19- MAY 25, 2014, WRITTEN BY LESLIE PICKER ON PAGE 40 TITLED “INVESTING: MEET THE FATHER OF THE MODERN IPO” WHERE THE UNDERWRITING AND STOCK SALES WERE UP 23 PERCENT IN 2013 FROM 2012. SO, IN REALITY, THE FEW REMAINING BIG INVESTMENT BANKS, PROMOTING THEIR TOXIC DERIVATIVES THROUGH THEIR HEDGE FUNDS ARE GAMBLING THAT IF THEY CREATED A BUBBLE SO BIG THAT WE WOULDN’T DARE LET THEM IMPLODE. WHAT WOULD BE WRONG IN GOING BACK TO SMALLER-RUN COMMERCIAL BANKS, PRIVATE AND PUBLIC, LIKE WHAT NORTH DAKOTA HAS, AS WELL AS A FEDERAL PUBLIC BANK, WHICH IS WHAT THEY SHOULD HAVE DONE WITH LEHMAN BROTHERS?
LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AARP Members
isely 