Treasury Secretary Henry M. Paulson Jr. left his suite at Manhattan’s Waldorf-Astoria Hotel last Sept. 15 after a sleepless night, feeling he’d done all he could to minimize the damage from that morning’s collapse of Lehman Brothers Holdings Inc., aides said.
At meetings concluded the previous evening at the Federal Reserve Bank of New York, Paulson and executives of the world’s largest financial institutions worked to head off two threats they anticipated in the wake of the biggest bankruptcy in U.S. history. The bankers spent hours trying to unwind Lehman-related credit-default swaps, bets made on whether companies will repay their debts. And with the help of a rule change by Federal Reserve Chairman Ben S. Bernanke, they were confident bank-to-bank loans would keep flowing.
“The general feeling was things were working,” said Phillip L. Swagel, Paulson’s assistant secretary for economic policy, who remained in Washington that weekend.
Nobody accounted for Bruce R. Bent. The 72-year-old graduate of St. John’s University in Queens, New York, created the first money market fund in 1971, the Reserve Primary Fund. He touted it as an investment so safe it would lull clients to sleep -- so safe that, even with $785 million in loans to tottering Lehman, Bent and his wife had jetted to Rome that Sunday evening to celebrate their 50th wedding anniversary.
$3.6 Trillion Market
Bent’s $62.5 billion fund had lent money to Lehman, mostly by acquiring short-term notes called commercial paper, used by companies to pay everyday expenses such as utilities and payroll and by Wall Street to fund everything from takeovers to the mortgages it turns into bonds. Money funds like Bent’s are the biggest buyers of commercial paper, purchasing about 40 percent of outstanding issues, according to the Fed.
It was commercial paper and the $3.6 trillion money market industry that traded the notes that came close to sinking the global economy -- not a breakdown in credit-default swaps or bank-to-bank lending. The bankers were focused on saving themselves, and commercial paper, as invisible as the air they breathed, never came up at the meetings, according to one of the two dozen executives invited to the New York Fed by its president, Timothy F. Geithner, 48, and Paulson.
‘Erosion of Trust’
Like ice-nine, the fictitious substance in Kurt Vonnegut Jr.’s 1963 novel “Cat’s Cradle,” a single seed of which could harden all the world’s water, commercial paper was the crystallizing force that froze credit markets, choking off the ability of companies and banks to borrow money and pay bills.
That a 158-year-old investment bank with $613 billion in liabilities could go belly up made every institution seem vulnerable. Within hours, investors were yanking money out of funds that just the day before seemed impregnable.
The ice-nine wasn’t noticed by most market participants at first, said Mohamed El-Erian, chief executive officer of Newport Beach, California-based Pacific Investment Management Co., the world’s largest fixed-income fund manager.
“Monday and Tuesday, people didn’t quite see what was happening,” El-Erian said in a July interview. “You had to be on the desk in the payments and settlements system, cash and collateral, to start seeing cascading market failures and a complete erosion of trust.”
The first victim was Reserve Primary. By 1 p.m. on Monday, Sept. 15, in New York, less than 13 hours after the 12:37 a.m. bankruptcy announcement, client demands for immediate cash-outs totaled $18 billion, more than a quarter of the fund’s assets. Even more alarming, Reserve Primary’s bank, Boston-based State Street Corp., had quit honoring withdrawal requests.
“The entire financial system was coming to a grinding halt incredibly rapidly,” Robert P. Kelly, CEO of Bank of New York Mellon Corp., the world’s biggest custody bank, recalled in an interview nine months later. “At the time, I don’t think the average American really understood how bad things were.”
Just before 2 p.m. on Monday, executives at New York-based Reserve Management Co. concluded that no one was willing to help them raise cash by purchasing their Lehman commercial paper.
“Paulson and Bernanke totally f---ed this up,” Reserve Chief Investment Officer Patrick R. Ledford said on a call with three colleagues, according to a transcript of the conversation obtained by the U.S. Securities and Exchange Commission and posted on the agency’s Web site. “I don’t think they thought this goddamned thing through, to figure out what the rippling effects would be.”
Paulson and Bernanke both declined to comment. Michele Davis, Paulson’s assistant secretary for public affairs, defended her boss.
“Nobody can point to what we could have done differently,” Davis said. “History will bear it out.”
On commercial paper desks all over Wall Street that Monday morning, phones that normally buzzed with employees renewing overnight loans were hushed.
“When there are significant concerns about credit risk, things get quiet in the CP market,” said Randy Harrison, head of short-term products at Citigroup Inc. in New York.
At the Bentonville, Arkansas, headquarters of Wal-Mart Stores Inc., there was more activity. Walmart had $250 million in Reserve Primary that it couldn’t get out, according to a lawsuit filed by the retailer against the fund and its management. Henry Ford Health System in Detroit and its affiliates had $414 million. San Francisco-based Visa USA Inc. had $982 million.
Pershing LLC, a Jersey City, New Jersey-based division of Bank of New York, rushed to remove $1.4 billion, according to e-mails published on the Massachusetts Secretary of the Commonwealth’s Web site.
All eyes in the industry were on Reserve because it was the fastest-growing group of funds and because of Bent’s stature, said Peter G. Crane, president of Westborough, Massachusetts- based Crane Data LLC, which tracks the money market.
For years, Bent had shunned commercial paper as too risky and scolded managers of other funds for sacrificing safety to earn higher yields, Crane said. Commercial paper is unsecured, meaning there’s no collateral to seize if the borrower doesn’t pay up.
Then, in August 2007 the commercial-paper and other credit markets froze as a result of deteriorating mortgage values. Banks such as Citigroup had funded the home loans in their structured investment vehicles, or SIVs, with commercial paper, and now the off-balance-sheet pools were collapsing because investors stopped purchasing their short-term notes. When SIV managers put their debt up for sale for as little as half the face value, Bent went on a buying spree, according to the Investment Company Institute, a fund-industry trade group in Washington.
‘Carrots and Peas’
“When they dumped it out into the marketplace, there were cats and dogs, and there were snakes, but there were also pearls,” the white-haired Bent said in an interview with Bloomberg in June 2008. “So I go through and I pick out the carrots and the peas, and the rest of the stuff I let it go.”
From July 2007 to July 2008, the commercial-paper portion of Reserve Primary’s holdings jumped to almost 60 percent from 1 percent, according to the trade association. The fund’s yield rose to 0.4 percentage point above the average among its peers in 2008 from slightly below average, a substantial increase by money market standards, the ICI said. The average yield was 1.96 percent in July 2008, according to Crane Data.
The higher yield, in turn, attracted more customers. Net assets in the fund grew to $67 billion in July 2008 from about $30 billion a year earlier, according to the trade group.
One of the “peas” Bent acquired as part of his move into commercial paper was debt issued by Lehman in August 2007. After the demise of Bear Stearns Cos., Reserve replaced $375 million of Lehman debt that matured in March 2008 with $385 million in new Lehman issues, the ICI reported. The Lehman investment eventually rose to $785 million.
By early September 2008, Reserve Primary was the third-highest yielding money fund out of 227 in the U.S., according to Crane. Bent, he said, “was on top of the world.”
“Everybody got drunk on the asset growth, not just him,” Crane said. “Money fund managers sat around as wallflowers for 20 years, and all of a sudden they’re in the limousine going to the party. Who doesn’t like that?”
On Sept. 15, while his flagship fund was sinking under the surge of redemption requests, Bent was speed-dialing from Rome.
“I’m not clairvoyant,” Bent said in an interview 10 months later. “I didn’t know Lehman was going to go under.”
Evergreen Investment Management’s three money market funds needed bailouts from their parent company, Wachovia Corp. Two funds run by Russell Investment Group were overwhelmed by callers demanding their money. So was Putnam Prime Money Market Fund, a victim of investors’ loss of confidence in just about everything. The Putnam fund had no investments in Lehman.
Colorado Diversified Trust, a pool created by local governments to park cash before using it to fix sidewalks or hire librarians, had bought $10 million of Lehman commercial paper on Sept 12, said Bob Hullinghorst, treasurer of Boulder County. Three days later the investment was worthless, he said.
The biggest credit-rating firms -- Standard & Poor’s, Moody’s Investors Service and Fitch Ratings Inc. -- all gave Lehman commercial paper their highest grades to the end.
“If people can’t rely on a top rating because the regulators aren’t there to supervise that and the agencies are not providing accurate ratings, where can we go?” said Hullinghorst, whose county wrote off $687,000 it had in the Colorado Diversified Trust. “Where can our money be safe?”
In a sign of distress, the yield of overnight commercial paper for top-rated non-financial companies climbed to 3.43 percent on Monday, Sept. 15, from 2.12 percent on Friday, Sept. 12, according to the Fed. It was the biggest one-day jump since the central bank began tracking the statistic in 1997.
Money funds are accustomed to clients, especially big institutions, moving cash in and out. Yields are so low that investors switch billions if a fund loses a single basis point, or 0.01 of a percentage point, compared with a rival. Cash that comes and goes even has a nickname: “hot money.”
While no rules mandate the practice or the amount, most funds keep a portion of their assets in cash to satisfy redemption requests. Money was leaving so fast on Sept. 15 that it was impossible to keep up. Fund executives spent most of the day trying to persuade clients not to withdraw their investments, said Kevin Kennedy, a New York-based portfolio manager for Western Asset Management Inc., a money fund that’s a division of Legg Mason Inc.
“If there are fires to put out, you can call your biggest customers, put an analyst on the phone and explain the situation,” Kennedy said.
Calling From Italy
Given the pressure of redemptions and the panic that investments would deteriorate in value, Kennedy said fund managers at his office strategized throughout the day.
“If we had thought about it more, maybe we would have jumped out of the window or something,” Kennedy said.
By 1 p.m. New York time, Bent had called into three of his own trustees’ meetings from Italy, according to a complaint filed May 5 by the SEC. The agency alleges that Bent and his son, Reserve President Bruce R. Bent II, committed fraud that week by misleading investors and trustees about the extent of losses in the fund and their ability to raise cash to prevent its collapse.
Both Bents have denied the charges in court filings.
Breaking the Buck
Money funds aim to maintain what’s called a net asset value, or NAV, of $1. That means every dollar an investor puts in is worth at least a dollar at all times. Gains are credited to customers and distributed monthly as cash or new shares. If a fund’s share value drops below $1 because of an investment loss, it’s called “breaking the buck.”
To calculate the NAV, a fund’s trustees need to be able to assign a value to their holdings. The previous week, Reserve Primary valued its short-term Lehman loans at 100 percent. On Sept. 15, the fund determined they were worth 80 cents on the dollar. The problem was, to pay all the investors who demanded money the fund needed to sell assets.
“The market was frozen, and nobody could buy or sell,” said Jack Winters, a retired 33-year veteran of the industry who worked for Federated Investors Inc., Fidelity National Financial Inc. and Lehman. “The only bids were low-ball. How do you set prices for securities in that environment?”
All funds that didn’t invest exclusively in U.S. government securities and needed to sell assets to meet client redemptions effectively broke the buck, Winters said.
“If you had to liquidate the portfolio there and then, you wouldn’t have had enough assets to redeem at $1 a share,” he said.
Paulson, who flew back to Washington from New Jersey’s Teterboro Airport at 9:50 a.m. on Sept. 15, according to his official schedule, had other worries. American International Group Inc., then the world’s biggest insurance company, was on the verge of a meltdown caused by bets its financial-products division had made on credit-default swaps. The next day the government would bail out the insurer with as much as $85 billion, reversing its position about saving failing institutions, making Lehman the sole systemically vital firm to fail under Paulson’s and Geithner’s watch.
Under the Radar
Money market funds flew under Paulson’s radar because they were considered cautious, said David Nason, assistant Treasury secretary for financial institutions at the time.
As long as they invested in debt with the highest credit ratings that matured in less than nine months, the rules for money funds as outlined in the Investment Company Act of 1940, regulators left the funds alone, said Nason, now a managing director of Promontory Financial Group, a financial-services consulting firm in Washington.
“The commercial paper market is largely unregulated,” Nason said. “It’s a nebulous area of credit that isn’t under the umbrella.”
At 5:45 p.m. on Sept. 15, General Electric Co. CEO Jeffrey R. Immelt met for half an hour with Paulson in the Treasury secretary’s office, according to Paulson’s schedule. At 7 p.m., Geithner convened a staff meeting at the New York Fed to focus on “GE issues,” according to his schedule, and he and Paulson conferred by phone afterward.
When Paulson and Geithner were searching for ways the previous weekend to mitigate the suffering that would follow a Lehman bankruptcy, they called on bankers. They didn’t call on GE Capital, GE’s finance unit, for advice. And when the bankers mapped out solutions, they hadn’t accounted for GE Capital.
Now regulators had to deal with Immelt, a New York Fed board member. GE Capital said it had borrowed $97 billion in commercial paper as of June 2008, more than any company or bank in the world.
Immelt eventually won approval for special government guarantees on up to $126 billion of borrowing, including backing for its commercial paper. GE says the program leveled the playing field for GE Capital to compete with other financial institutions, especially banks.
The episode humbled GE Capital, dragging down GE shares to a low of $6.66 on March 5 from $26.75 on the Friday before Lehman’s bankruptcy. They have since rebounded to about half their Sept. 12, 2008, value.
On Tuesday, Sept. 16, the run on Reserve Primary continued. Between the time of Lehman’s Chapter 11 announcement and 3 p.m. on Tuesday, investors asked for $39.9 billion, more than half of the fund’s assets, according to Crane Data.
The younger Bent told the fund’s directors that he appealed by phone to the New York Fed for help securing financial support. He said he left a message with a receptionist.
Reserve’s trustees instructed employees to sell the Lehman debt, according to the SEC.
They couldn’t find a buyer.
At 4 p.m., the trustees determined that the $785 million investment was worth nothing. With all the withdrawals from the fund, the value of a single share dipped to 97 cents.
“They had Lehman and hot money -- that’s a bad combination,” said Kennedy of Western Asset Management. “Just the fact that this could possibly happen sent ripples through the entire industry.”
Only one other fund had ever broken the buck -- the much smaller Community Bankers Mutual Fund in Denver, which liquidated its $82.2 million of assets in 1994.
Legg Mason, Janus
“Bruce Bent told everybody he was safer than anybody else, but looking back he was the same as everybody else,” said Mark Schild, president of Beech Hill Securities Inc. in Millburn, New Jersey, who had clients invested in the fund. “Other funds would have broken the buck, but they all had big institutions to feed them money. Reserve didn’t.”
Legg Mason, Janus Capital Group Inc., Northern Trust Corp., Evergreen and Bank of America Corp.’s Columbia Management investment unit were all able to inject cash into their funds to shore up losses or buy assets from them. Putnam closed its Prime Money Market Fund on Sept. 18 and later sold its assets to Pittsburgh-based Federated Investors.
At least 20 money fund managers were forced to seek financial support or sell holdings to maintain their $1 net asset value, according to documents on the SEC Web site.
No Deep Pockets
Reserve Primary had no parent with deep pockets. While the Bents said they tried to sell the fund that week, they couldn’t.
“It was like trying to measure wind speed in the middle of a hurricane when the speed is changing constantly -- in all directions,” Bruce Bent II said in an April 29 e-mail interview with Bloomberg News.
When news that Reserve Primary broke the buck hit the wires at 5:04 p.m. that Tuesday, the race was on.
“The best way to get your dollar back is to ask for it before anybody else,” said Roger Merritt, who heads the fund- rating team at Fitch in New York.
It was already too late for Willard Scolnik, a 78-year-old retired architect in Palm Harbor, Florida.
Scolnik was visiting his son Stuart in Washington on Sept.
16. He was watching a financial news channel a little after 5 p.m. with his son’s dog, Bella, on his lap when he heard that Reserve Primary had fallen below $1.
He flipped open his phone and started dialing.
Scolnik said his $400,000 in the fund was earmarked for living expenses and a lung transplant for his other son, David.
“My reason for being with Reserve Primary was they were supposed to be conservative, and they told us that we could sleep well knowing they would do nothing to cause us any pain,” Scolnik said of the fund. “So, big shock.”
While bank deposits were insured to $100,000, money market funds weren’t insured at all.
By Sept. 17, Scolnik still hadn’t received his money. Neither had Walmart nor Goodyear Tire & Rubber Co., the biggest U.S. tiremaker, which had $360 million stuck in Reserve Primary. With nowhere else to go, the Akron, Ohio-based company tapped a revolving credit line, paying 5.93 percent interest. The overnight rate for commercial paper issued by companies with Goodyear’s credit status was 2.67 percent on Sept. 12.
That same day investors took $78.7 billion out of money funds, according to Crane Data. By the end of the week, $230 billion was gone from the $3.6 trillion industry.
Also that Wednesday Paulson ordered senior adviser Steven Shafran to lead a team to devise a plan for stemming the run in the money markets. Shafran had worked at Goldman Sachs Group Inc. with Paulson, who was CEO of the firm before becoming Treasury secretary in 2006. The team worked round the clock with the Fed to find a way to plug hemorrhaging funds, said Swagel, the former assistant secretary.
“We had conference calls late into the night on money market funds and commercial paper, until midnight with the Fed in Washington and the Fed in New York,” said Swagel, now a visiting finance professor at Georgetown University’s McDonough School of Business in Washington. “And then we got on the phone again at 2 in the morning. We worked, went back and worked more. We wanted to flush the system with liquidity.”
Scolnik returned to his home in Florida. He couldn’t sleep. He worried that David would die without his father to help him.
“I am his only fallback, and I’m concerned that should I go to my next assignment, he has some help,” Scolnik said.
By late Thursday night, the Treasury and Fed were ready to stop the carnage. The next morning, Sept. 19, the government announced a temporary guarantee for money market funds, a $50 billion insurance program that backed all shares. The backstop remains in effect through Sept. 18.
The European Central Bank also stepped in to aid European banks left without a source of funding when the U.S. commercial-paper market froze and the ice-nine spread across the Atlantic. An average of 22 percent of the commercial-paper holdings of the 15 largest U.S. money funds last year were issued by European financial institutions, according to a March 2009 report by the Bank for International Settlements in Basel, Switzerland.
On Sept. 18, the ECB announced that it was prepared to increase funding in dollars to European banks to as much as $110 billion, an amount later upped to $240 billion.
The Fed created a special fund, the Commercial Paper Funding Facility, on Oct. 7 to buy hard-to-sell short-term loans. Two weeks later it established the Money Market Investor Funding Facility to make loans of longer maturities.
“Industry assets might still be frozen today if the Treasury had not guaranteed all money funds and if the Fed had not provided a number of liquidity sources,” Winters, the industry veteran, wrote in a July 23 letter to the SEC.
After two panics in two years, the SEC has proposed new rules to govern money markets. The commission suggested a floating net asset value linked to market prices, instead of a stable $1 NAV tied to the expected value of holdings when they mature. That way, share prices would drop as soon as a fund experienced a loss. If a fund’s value fell below $1 to, say, 97 cents, clients who rushed to withdraw their money would get only 97 percent of their investment, removing the incentive to withdraw quickly and preventing a run.
The Obama administration has directed the President’s Working Group on Financial Markets to consider the floating NAV and report back by Dec. 1.
“The widespread run on money market mutual funds has underscored the dangers of institutions with no capital, no supervision and no safety net,” the Group of 30, a financial advisory organization that includes former Fed Chairman Paul A. Volcker, said in a January report.
Money funds undermine the strength of the U.S. financial system and should be regulated more like banks, Volcker said in an August interview. They should submit to the same “regulatory burden,” he said.
The SEC recommended that funds hold a certain percentage of their assets in cash, so they can make payments in times of stress. Regulators also proposed upgrading the quality of the assets that funds can own and limiting them to securities with shorter maturity dates.
“The current proposed rule amendments will decrease the risks of money market funds but would not prevent another Reserve-style panic,” said Peter Rizzo, director of fund ratings at S&P in New York. “If you want a scenario where nobody ever loses money again in the money market funds, that won’t happen.”
In addition to the SEC case, the Bents face at least 30 lawsuits from clients who claim they didn’t live up to their promise to pay promptly and in full.
Walmart, which got $200 million back from Reserve Primary, is suing to recover its additional $50 million.
Though his son David’s health has deteriorated, Scolnik said he hasn’t yet needed a lung transplant. Scolnik is suing to recover the $50,000 he didn’t get back after Reserve liquidated its assets.
“It makes me feel awful, vulnerable,” he said. “Next time I won’t trust anyone.”
(Lehman’s Lessons: Next, Hong Kong Minibonds)