According to a WSJ article today, the Lehman Brothers bankruptcy two weeks
ago has caused a sharp forced selling chain reaction, which is continuing
today, and contributed to the 7-9% Wall Street collapse today:
http://online.wsj.com/article/SB1222661 ... od=testMod
* SEPTEMBER 29, 2008
Lehman's Demise Triggered
Cash Crunch Around Globe
Decision to Let Firm Fail Marked a Turning Point in Crisis
By CARRICK MOLLENKAMP and MARK WHITEHOUSE in London, JON HILSENRATH in
Washington and IANTHE JEANNE DUGAN in New York
Two weeks ago, Wall Street titans and the government's most powerful
economic stewards made a fateful choice: Rather than propping up
another failing financial institution, they let 158-year-old Lehman
Brothers Holdings Inc. collapse.
Now, the consequences of that decision look more dire than almost
anyone imagined.
[A policeman tries to calm and direct customers crowding the entrance
of a branch of Hong Kong] AFP/Getty Images
A policeman tries to calm and direct customers crowding the entrance
of a branch of Hong Kong's Bank of East Asia after rumors spread about
BEA's exposure to assets linked to failed investment bank Lehman
Brothers.
Lehman's bankruptcy filing in the early hours of Monday, Sept. 15,
sparked a chain reaction that sent credit markets into disarray. It
accelerated the downward spiral of giant U.S. insurer American
International Group Inc. and precipitated losses for everyone from
Norwegian pensioners to investors in the Reserve Primary Fund, a U.S.
money-market mutual fund that was supposed to be as safe as cash.
Within days, the chaos enveloped even Wall Street pillars Goldman
Sachs Group Inc. and Morgan Stanley. Alarmed U.S. officials rushed to
unveil a more systemic solution to the crisis, leading to Sunday's
agreement with congressional leaders on a $700 billion
financial-markets bailout plan.
The genesis and aftermath of Lehman's downfall illustrate the
difficult position policy makers are in as they grapple with a
deepening financial crisis. They don't want to be seen as too willing
to step in and save financial institutions that got into trouble by
taking big risks. But in an age where markets, banks and investors are
linked through a web of complex and opaque financial relationships,
the pain of letting a large institution go has proved almost
overwhelming.
In hindsight, some critics say the systemic crisis that has emerged
since the Lehman collapse could have been avoided if the government
had stepped in. Before Lehman, federal officials had dealt with a
series of financial brushfires in a way designed to keep troubled
institutions such as Fannie Mae, Freddie Mac and Bear Stearns Cos. in
business. Judging them as too big to fail, officials committed
billions of taxpayer dollars to prop them up. Not so Lehman.
"I don't understand why they didn't understand that the markets would
be completely spooked by this failure," says Richard Portes, professor
of economics at London Business School and president of the Centre for
Economic Policy Research. Rather than showing the government's
resolve, he says, letting Lehman fail only exacerbated the central
problem that has afflicted markets since the financial crisis began
more than a year ago: Nobody knows which financial firms will be able
to make good on their debts.
To be sure, Lehman's downfall was largely of its own making. The firm
bet heavily on investments in overheated real-estate markets, used
large amounts of borrowed money to supercharge its returns, then was
slower than others to recognize its losses and raise capital when its
bets went wrong. The depth of the firm's woes made finding a willing
buyer a difficult task, leaving officials with few viable options.
Given the limited time and information available, many experts believe
government officials made the best choices possible.
Struggle for Capital
As they watched Lehman struggle to raise capital, policy makers --
including Treasury Secretary Henry Paulson, Federal Reserve Chairman
Ben Bernanke and New York Fed President Timothy Geithner -- mulled the
question of whether they could let Lehman fail. On the one hand, they
didn't want to come to the rescue because they were concerned about
moral hazard, the idea that bailouts encourage irresponsible
risk-taking, according to people familiar with the planning. They
doubted Lehman had viable buyers and they thought the market and the
Fed had had time to prepare to handle the fallout if a big institution
collapsed. Still, some Fed officials were leery of sending signals
that the Fed was done working with Wall Street to stop the spreading
crisis. Mr. Geithner, for one, had been telling others that the
markets were still in for serious trouble.
"If you don't do something, the outcome is going to be bad," Mr.
Geithner told executives as they gathered to bargain over Lehman's
fate at the New York Fed's downtown headquarters on Friday night,
Sept. 12, according to a person in the meeting.
At one point, officials raised with Wall Street bankers the
possibility of a private-sector rescue fund, but the bankers either
balked at the idea of bailing out a competitor or didn't have the
extra funds needed, people familiar with the situation said.
Prepare the Markets
Over the weekend, as possible buyouts by Bank of America Corp. and
U.K. bank Barclays PLC fell through, Fed officials focused on what
needed to be done to prepare markets for what would be the largest
bankruptcy in U.S. history. Lehman's total assets of more than $630
billion dwarf WorldCom's assets when the telecom company filed for
bankruptcy in 2002 with assets of $104 billion.
Officials were particularly concerned with two areas: the
credit-default-swap market, where players buy and sell insurance
against defaults on corporate and other bonds; and the so-called repo
market, where Wall Street banks fund their investments by putting up
securities as collateral for short-term loans.
The Fed had been pushing Wall Street firms for months to set up a new
clearinghouse for credit-default swaps. The idea was to provide a more
orderly settlement of trades in this opaque, diffuse market with a
staggering $55 trillion in notional value, and, among other things,
make the market less vulnerable if a major dealer failed. But that
hadn't gotten off the ground. As a result, nobody knew exactly which
firms had made trades with Lehman and for what amounts. On Monday,
those trades would be stuck in limbo. In a last-ditch effort to ease
the problem, New York Fed staff worked with Lehman officials and the
firm's major trading partners to figure out which firms were on
opposite sides of trades with Lehman and cancel them out. If, for
example, two of Lehman's trading partners had made opposite bets on
the debt of General Motors Corp., they could cancel their trades with
Lehman and face each other directly instead.
The Fed had also seen with the collapse of Bear Stearns how the repo
market was prone to severe disruptions when lenders got skittish, a
problem that threatened to cut off crucial funding to Wall Street
banks. Because repo loans are made for periods of as little as a day,
the funding can disappear suddenly -- one reason the Fed set up an
emergency facility to lend to securities firms in the wake of Bear
Stearns's collapse. Fed officials worked furiously through Sunday to
expand that facility, allowing banks to put up as collateral for loans
a wider range of securities, including stocks.
On Sunday, after the Barclays deal fell through, the group began to
"spray foam on the runway" -- the term Mr. Geithner used to describe
measures to cushion the blow. By that night, Fed officials recognized
that their preparations might not cover all contingencies. Still, they
expected the turbulence to settle down after a time, with the help of
the expanded lending facilities they hurried Sunday to put in place.
They also felt that financial institutions and markets had been given
enough time to prepare for the shock of a large failure since the
crisis consumed Bear Stearns in March.
But Lehman's bankruptcy, filed early Monday morning in federal
bankruptcy court -- case No. 08-13555 -- proved far more
destabilizing, and spread much further, than many had expected. The
bankruptcy immediately wiped out huge investments for Lehman
shareholders and bondholders. Among the biggest was Norway's
government pension fund, which invests the country's surplus oil
revenue. As of the end of 2007, the most recent data available, the
fund owned more than $800 million worth of Lehman bonds and stock.
Lehman's demise has become a lightning rod for critics who have long
questioned the way the government was investing the oil resources. A
spokesman said the fund's management is "very concerned and monitoring
the situation closely."
The government's decision to let Lehman go marked a turning point in
the way investors assess risk. When the Fed stepped in to engineer the
takeover of Bear Stearns by J.P. Morgan Chase & Co. in March, Bear's
shareholders lost most of their investments, but bondholders came out
well. In the financial hierarchy of risk, this wasn't surprising,
since bondholders have more contractual rights to get their money back
than equity holders. But it created a false impression among investors
that the government would step in to rescue bondholders when the next
bank ran into trouble. By letting Lehman fail, the government had
suddenly disabused the market of that notion.
The reaction was most evident in the massive credit-default-swap
market, where the cost of insurance against bond defaults shot up
Monday in its largest one-day rise ever. In the U.S., the average cost
of five-year insurance on $10 million in debt rose to $194,000 from
$152,000 Friday, according to the Markit CDX index.
When the cost of default insurance rises, that generates losses for
sellers of insurance, such as banks, hedge funds and insurance
companies. At the same time, those sellers must put up extra cash as
collateral to guarantee they will be able to make good on their
obligations. On Monday alone, sellers of insurance had to find some
$140 billion to make such margin calls, estimates asset-management
firm Bridgewater Associates. As investors scrambled to get the cash,
they were forced to sell whatever they could -- a liquidation that hit
financial markets around the world.
Cash Calls
The cash calls added to the problems of AIG, which was already
teetering toward collapse as it sought to meet more than $14 billion
in added collateral payments triggered by a downgrade in its credit
rating. AIG was one of the biggest sellers in the default insurance
market, with contracts outstanding on more than $400 billion in
bonds.
To make matters worse, actual trading in the CDS market declined to a
trickle as players tried to assess how much of their money was tied up
in Lehman. The bankruptcy meant that many hedge funds and banks that
were on the profitable side of a trade with Lehman were now out of
luck because they couldn't collect their money. Also, clients of
Lehman's prime brokerage, which provides lending and trading services
to hedge funds, would have to try to retrieve their money or their
securities through the courts.
Autonomy Capital Research, a London-based hedge fund that was started
in 2003 by former Lehman trader Robert Charles Gibbins, was among the
Lehman clients who got caught. When Lehman filed for bankruptcy
protection, it froze about $60 million of Autonomy's funds, according
to a person close to the situation. That is about 2% of the $2.5
billion Autonomy manages. An official at Autonomy declined to
comment.
Spooked that other securities firms could fail, hedge funds rushed to
buy default insurance on the firms with which they did business. But
sellers were hesitant, prompting something akin to what happens if
every homeowner in a neighborhood tries to buy homeowners insurance at
exactly the same time. The moves dramatically drove up the cost of
insurance on Morgan Stanley and Goldman Sachs debt in what became a
dangerous spiral of fear about those firms.
At the same time, hedge funds began pulling their money out of the two
firms. Over the next few days, for example, Morgan Stanley would lose
about 10% of the assets in its prime-brokerage business.
"It was just mayhem," says Thomas Priore, the CEO of New York-based
hedge fund Institutional Credit Partners LLC. "People were paralyzed
by fear of what could erupt."
Amid the uncertainty about how Lehman's bankruptcy would affect other
financial institutions, rumors and confusion sparked wild swings in
stock prices. On Tuesday, for example, a London-based analyst issued a
report saying that Swiss banking giant UBS AG, already hurt by tens of
billions of dollars in write-downs, might lose another $4 billion
because of its exposure to Lehman. Shares in UBS fell 17% on the day.
UBS subsequently said its exposure was no more than $300 million.
Rising concerns about the health of financial institutions quickly
spread to the markets on which banks depend to borrow money. At around
7 a.m. Tuesday in New York, the market got its first jolt of how bad
the day was going to be: In London, the British Bankers' Association
reported a huge rise in the London interbank offered rate, a benchmark
that is supposed to reflect banks' borrowing costs. In its sharpest
spike ever, overnight dollar Libor had risen to 6.44% from 3.11%. But
even at those rates, banks were balking at lending to one another.
Within a few hours, the markets had shifted their focus to the fate of
Goldman Sachs and Morgan Stanley, which found themselves fighting to
restore investors' flagging confidence. During an earnings
presentation in which he answered one after another question about the
firm's ability to borrow money, Goldman chief financial officer David
Viniar made an admission: "We certainly did not anticipate exactly
what happened to Lehman," he said.
Morgan Stanley's stock, meanwhile, plunged 28% in early trading as
investors bet that it would be the next after Lehman to fall. At
around 4 p.m., the firm decided to report its third-quarter earnings a
day early, in the hope that the decent results would halt the stock
decline.
"I care that it could be contagion," Morgan Stanley chief financial
officer Colm Kelleher said in a conference call with analysts. "You've
got fear in the market."
Even as Morgan Stanley's call was taking place, the Lehman fallout
cropped up in a different corner of finance: so-called money-market
funds, widely seen as a safe alternative to bank deposits. Many of the
funds had bought IOUs, known as commercial paper, which Lehman issued
to borrow money for short periods. Now, though, the paper was worth
only 20 cents on the dollar.
At around 5 p.m. New York time, a well-known money-market fund manager
called The Reserve said that its main fund, the Reserve Primary Fund,
owned Lehman debt with a face value of $785 million. The result, said
The Reserve, which had criticized its rivals for taking on too much
risk in the commercial-paper market, was that its net asset value had
fallen below $1 a share -- the first time a money-market fund had
"broken the buck" in 14 years.
The trouble in the commercial-paper market presented a particularly
serious threat to the broader economy. Companies all over the world
depend on commercial paper for short-term borrowings, which they use
for everything from paying salaries to buying raw materials. But as
jittery money-market funds pulled out, the market all but froze.
On Wednesday, the freeze in lending markets triggered a dramatic turn
of events in the U.K. Amid growing concerns about its heavy dependence
on markets to fund its business, HBOS PLC, the UK's biggest mortgage
lender, saw it share price plummet by 19%. The situation was a red
flag for government officials, who suffered embarrassment earlier this
year when they were forced to nationalize troubled mortgage lender
Northern Rock PLC, which had become the target of the country's first
bank run in more than a century.
Moving quickly, the government brokered an emergency sale of HBOS to
U.K. bank Lloyds TSB Group PLC. In a sign of their desperation to make
the deal happen, officials went so far as to amend the U.K.'s
antitrust rules, which could have prevented the merger. Together, HBOS
and Lloyds control nearly a third of the U.K. mortgage market.
Back in New York, the situation at Morgan Stanley and Goldman Sachs
was worsening rapidly. In the middle of the trading day, at about 2
p.m., Morgan Stanley CEO John Mack dispatched an email to employees:
"What's happening out here? It's very clear to me -- we're in the
midst of a market controlled by fear and rumors." By the end of
Wednesday, employees at Morgan Stanley and Goldman were shell-shocked.
Morgan Stanley's shares had fallen 24% to $21.75 while Goldman, the
largest investment bank by market value, fell 14% to $114.50.
By Thursday, Messrs. Paulson and Bernanke decided that the fallout
presented too great a threat to the financial system and the economy.
In the biggest government intervention in financial markets since the
1930s, they extended federal insurance to some $3.4 trillion in
money-market funds and proposed a $700 billion plan to take bad assets
off the balance sheets of banks.
Three days later, Goldman Sachs and Morgan Stanley applied to the Fed
to become commercial banks -- a historic move that ended the tradition
of lightly regulated Wall Street securities firms that take big risks
in the pursuit of equally big returns.
To some, the government's decision to resort to a bailout represents a
tacit admission: For all officials' desire to allow markets to punish
the risk-taking that engendered the crisis, banks have the upper hand.
"Lehman demonstrated that it's much harder than we thought to deal
effectively with banks' misbehavior," says Charles Wyplosz, an
economics professor at the Graduate Institute in Geneva. "You have to
look the devil in the eyes and the eyes are pretty frightening."
—Sue Craig in New York, Michael M. Phillips in Washington and Neil
Shah in London contributed to this article.
Write to Carrick Mollenkamp at
carrick.mollenkamp@wsj.com, Mark
Whitehouse at
mark.whitehouse@wsj.com, Jon Hilsenrath at
jon.hilsenrath@wsj.com and Ianthe Jeanne Dugan at
ianthe.dugan@wsj.com