by Neil Irwin
As the mortgage securities AIG guaranteed lost value, its clients—global banks including the French Société Generale, Germany’s Deutsche Bank, and the United States’ Goldman Sachs—demanded that AIG put up billions of dollars to ensure it would make good on the potential losses. But the firm’s insurance arms were heavily regulated and couldn’t just shift cash over to its financial products division.
Typically, AIG could have easily borrowed money in order to buy itself time to sell off some of its profitable businesses. But the banks were hardly in the mood to extend $75 billion in loans to a troubled company. They had their own problems—becoming the next Lehman chief among them. Raising the money on the stock market wasn’t an option either. After Lehman Brothers filed for bankruptcy protection that Monday morning, the Dow Jones Industrial Average fell 504 points, one of the largest single-day drops in its history, and many of the overseas investors who had made large-scale investments in big U.S. financial companies in the earlier phase of the crisis had seen their money all but wiped out. The appetite of investors for new shares of a troubled insurer was nonexistent.
Geithner became convinced that the collapse of AIG would be catastrophic for the financial system—even though, as late as Lehman Brothers weekend, essentially no one within the Federal Reserve understood the risks the company had been taking or what might happen if it were to go under. The Office of Thrift Supervision was nominally in charge of overseeing AIG, due to the firm’s long-ago acquisition of a savings and loan, but this most hapless of U.S. financial regulators was hardly up to the task of regulating a company that large and complex.
Fed leaders had to do some very quick, very scary guesstimation. “The failure of AIG, in our estimation, would have been basically the end,” Bernanke said in a lecture years later. “It was interacting with so many different firms. . . . We were quite concerned that if AIG went bankrupt, we would not be able to control the crisis any further.” There was, at least, a plausible option for the Fed—unlike with Lehman, for which there had been no good legal options for a bailout. This time, Washington wouldn’t let down the world. Under the same “unusual and exigent” emergency lending authority it had used with Bear Stearns, the central bank could make the multibillion-dollar loan to AIG that private banks were at that moment unable or unwilling to make. The loan would, in a sense, be “secured” by AIG’s insurance businesses, which the firm would have to sell in order to raise repayment funds. But there was no way to know for sure if taxpayers would ever get their money back.
When Bernanke and Paulson went to Capitol Hill the evening of Tuesday, September 16, to explain their plan for a Fed bailout of AIG, the reaction was one of incredulity. Senate majority leader Harry Reid clutched his head in his hands. “I want you to understand that you have not received the official blessing of Congress,” he said.
“Do you have $80 billion?” asked Representative Barney Frank, to which Bernanke replied, “I have $800 billion,” referring to the size of the Fed’s balance sheet at the time. If anything, that understated the resources at Bernanke’s disposal: For an institution that can print money, there are no real limits.
Bernanke and Geithner, in their own minds, applied a rigorous and ruthless logic when making their decisions about which institutions they would bail out and which they wouldn’t. They depended on the exact financial circumstance of the company in question and the legal options available. To the outside world, though, their actions looked simply like flailing around.
A metaphor in wide circulation in the fall of 2008 was of dominoes: One investment bank falls, knocking over an insurance company, knocking over a commercial bank, and so on. But, as Bush adviser Edward P. Lazear would argue later, a more apt comparison was with popcorn. Rather than one failure predictably following another, they happened nonsequentially, as if the financial firms were all kernels of popcorn in a pan. There was one common source of heat: the realization that losses on a wide range of securities—mortgages at first, but ultimately lots of other kinds of lending—were going to be far greater than anyone had imagined possible. The kernels don’t pop at the same time; some don’t pop at all. But they were all exposed to heat. The great struggle for the world’s central bankers in the days after AIG was to find a way to turn off the stove.
On September 16, as Bernanke and Geithner focused on what to do about AIG, another kernel looked ready to explode. Reserve Management Co. was one of the earliest innovators of a product that had transformed the way many people around the world save, as well as how many companies fund themselves. Introduced in 1971, the Reserve Primary Fund, like all money market mutual funds, performed many of the functions of a bank, both for savers and for borrowers, but without all the costly regulation and overhead of a bank. What does a bank do? It takes money from people who wish to save and lends it out to others who wish to invest. A money market mutual fund does the same thing: Savers deposit money, and the managers of the fund invest that money in safe, short-term investments—commercial paper issued by General Electric to manage its cash flow, for example, or Treasury bills issued by the U.S. government. Or the repurchase agreements that investment banks use to fund themselves.
Unlike a bank, though, a money market fund doesn’t have to maintain a large cushion of capital—it invests nearly all of its investors’ money in securities. It doesn’t have the costly overhead of bank branches and tellers, so it can generally pay a higher rate of interest to savers and demand lower interest rates from borrowers. But it also lacks the range of government guarantees that the banking system has—federal deposit insurance, as well as access to emergency Fed lending. Indeed, the funds exploded in popularity in the 1970s and ’80s in no small part to get around regulations, specifically caps on bank interest rates. Nonetheless, the investments seemed so safe that Americans parked their cash in them in remarkable quantities: $3.8 trillion by August 2008, or $12,000 for each American man, woman, and child, more than half the total amount of money on deposit at U.S. banks.
The Reserve Primary Fund accounted for only $62 billion of that total. And of its $62 billion in assets, only a bit more than 1 percent—$785 million—was invested in securities from Lehman Brothers. Yet when Lehman went under, the entire fund came close to collapse. From its public disclosures, investors were well aware that the Reserve Primary Fund had significant investments in Lehman. The evening of Sunday, September 14, as the investment bank appeared headed for bankruptcy, Reserve Fund managers fretted that they could see people withdrawing money from the fund as a result—up to $1.5 billion, they figured, according to e-mails that became public in subsequent litigation. At 8:37 a.m. on Monday, they had already received $5 billion in redemption requests.
When people demanded their money back, it meant that the fund’s managers needed to sell other assets to get the necessary cash. And the week of September 14, 2008, was one of the worst weeks in the history of finance to try to sell commercial paper and other short-term investments. The Reserve Primary Fund may not have been a bank, but it was experiencing a run on the bank nonetheless. It announced Tuesday evening that it would have to “break the buck,” meaning that shares in the fund normally worth $1 would in fact be worth only 97 cents.
In response, investors started pulling their money out of other money market funds, making $169 billion in withdrawals the very next day. A vicious cycle was setting in: As investors yanked their money from the funds, the funds were forced to dump commercial paper into the market to free up cash, causing their value to fall further, creating more losses. At the same time, the withdrawals threw into doubt the funding that many U.S. corporations use to pay for everyday operations.
As the New York Fed’s market monitoring staffers made their daily calls to sources on the trading desks of Wall Street and beyond, and more senior Fed officials sounded out old contacts of their own, they were told of a situation that seemed on the verge of spinning out of control: More funds would break the buck, putting $
3.8 trillion of Americans’ savings at risk. And all that money being pulled out of mutual funds meant less cash available for banks, as well as companies that fund their operations with commercial paper. If the money market funds went, so would the solvency of banks that had weathered the collapse of Lehman and the near collapse of AIG, along with the ability of much of corporate America to make its payroll.
“We came very, very close to a depression,” Bernanke told Time magazine in 2009. “The markets were in anaphylactic shock.”
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Modern economies can be astonishingly resilient to shocks. Pop a giant stock bubble, as occurred during the dot-com crash of the early 2000s, and the downturn might be mild as investors lick their wounds, capital is diverted to other uses, Webvan employees get new jobs, and everybody goes about their business. But mess with the very core of the financial system—people’s confidence that their savings are secure—and the consequences are far more dire.
The idea that money itself may be unsafe triggers an almost primal fear in even the most levelheaded of investors. The problem in the Panic of 2008 wasn’t that some investments lost value. It’s that many of the investments that lost value—money market mutual funds being a prime example—had been viewed as absolutely safe. The basic reality of modern monetary systems had been laid bare: Money is simply an idea, a concept—a giant confidence game, even. People wanted out.
That was the feeling in the air that week in September 2008. The question was, what would the world’s central bankers do about it? Could Walter Bagehot’s time-honored approach to stopping a panic—lending freely to illiquid, not insolvent, firms at a penalty interest rate—be made to work when the panic was happening almost everywhere on earth at the same time, and in markets where traditional rules didn’t apply?
The Fed’s strategy for dealing with the panic was emblematic of its overall approach to the crisis. Bernanke, the Great Depression scholar, had particular admiration for Franklin Delano Roosevelt’s strategy during the 1930s. Not every program his administration undertook did much good, but there was a spirit of experimentation, of throwing everything the government had against the wall to see what would stick. As the money market funds trembled, Bernanke directed his troops to adopt the same approach: Try everything.
First, just three days after the Reserve Fund broke the buck, came the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, or AMLF. With Fed staffers in New York and Washington already stretched thin with crisis fighting, the program was administered by the Federal Reserve Bank of Boston, which had particular expertise in money market funds: The city is home to a number of the major mutual fund groups, as well as State Street, a bank that carries out transactions for many of the funds. The idea was to use infrastructure that had long been in place to channel money to banks to back up the money market funds instead. The Fed would lend money to banks, which could then buy the securities the money market funds were selling off and pledge them to the Fed, with the banks themselves taking no financial risk for their role as intermediary.
The program lent out $24 billion on its first day of operation, September 22, 2008, and $217 billion before the panic wound down, routing money through banks like State Street and J.P. Morgan Chase to mutual funds run by household-name companies such as Janus and Oppenheimer. To satisfy the Fed’s lawyers, the program could accept commercial paper backed only by specific assets, such as credit card loans due. But with a buyer in the market for even just a subset of the securities they owned, the money market funds could raise enough money to avoid breaking the buck.
It took a little longer to come up with the next mode of attack. The Commercial Paper Funding Facility, announced on October 7, focused on the other side of the same problem, the difficulty companies were having selling their commercial paper, due in large part to the money market funds not being available as a buyer. With the CPFF, the Fed used its 13(3) authority to lend money in “unusual and exigent circumstances” to fund a “special purpose vehicle” (SPV) that purchased commercial paper from eligible issuers. Participants in the program could sell to the SPV only after paying a fee of 0.1 percent of their total commercial paper balance—a requirement designed to provide the Fed some measure of protection. If some of the borrowers defaulted, the theory went, any losses would be covered by those fees—in other words, by the companies that took part in the program, not taxpayers.
Before it was all over, in early 2010, some $738 billion in commercial paper had been purchased from affiliates of eighty-two different companies. Big banks, both domestic and foreign, were on the list. So were some of the mainstays of the U.S. corporate sector. Verizon used the program on two successive days in late October 2008, borrowing a combined $1.5 billion. The finance arm of Harley-Davidson turned to the CPFF thirty-three times for a combined $2.3 billion, helping ensure it could continue making loans to potential buyers of its motorcycles. The major American auto firms’ finance arms—Ford Credit, GMAC, Chrysler Financial Services—all took part in the program. So did General Electric. Golden Funding Corp., which lends to McDonald’s franchisees so they can build or renovate their restaurants, turned to the CPFF eight times for a total of $203 million, helping ensure the continued availability of Big Macs across the land.
In the Rooseveltian spirit of experimentation, the Fed created so many emergency lending facilities that a document just listing and summarizing them required a legal-sized piece of paper covered in small type. There was even a complex program called the Money Market Investor Funding Facility, announced on October 21, that never lent a single dime. The MMIFF aimed to create another place where the money market funds could dump their holdings—but Fed staff couldn’t figure out how to make the program attractive to participants while also protecting taxpayers against losses, an ongoing problem in emergency lending.
At the time, commentators often asked: Where’s the money going? Exactly who’s borrowing from the Fed? The answers, revealed by information made available only much later, turned out to be everywhere—and everyone. Wrote Time magazine, in naming him its “Person of the Year,” Bernanke “conjured up trillions of new dollars and blasted them into the economy; . . . lent to mutual funds, hedge funds, foreign banks, investment banks, manufacturers, insurers and other borrowers who had never dreamed of receiving Fed cash; jump-started stalled credit markets in everything from car loans to corporate paper; . . . and generally transformed the staid arena of central banking into a stage for desperate improvisation.”
No wonder his eyes look tired.
The shock of the Lehman failure quickly spread across the Atlantic. The thing that European banks had feared since August 2007—that another major bank might have such grave losses on its books that lending money to it would be dangerous—had happened. If Lehman Brothers could go belly up, couldn’t any big bank? And that being the case, why would a banker willingly lend dollars to one of his competitors for interest rates of only a couple percent? As had been the case in late 2007, dollars were in particularly short supply, a problem for banks that might be headquartered in Frankfurt or Zurich or Paris but had vast quantities of dollar loans on their balance sheets.
The lending rate between banks, which typically wouldn’t have been higher than the 2 percent target the Fed then had in place, soared to over 5 percent in the weeks after the Lehman bankruptcy. That’s a misleading number, though: It really reflects a market that had shut down, with lots of entities out there hoping to borrow dollars but no one willing to lend. Interbank lending just wasn’t happening. As a result, even banks that could easily weather direct losses from money they were owed by Lehman found themselves unable to get the cash they needed to meet their daily obligations. Due to the unusual status of the dollar as the closest thing there is to a global currency, there was a worldwide shortage of dollars that threatened to bring down the entire global economy.
“This is clearly outside the textbook case of a fin
ancial crisis,” said Stefan Ingves, governor of Sweden’s central bank, the Riksbank. “We couldn’t just create our own currency to lend to the banks. We can’t produce dollars, and we can’t produce euros.”
The panic quickly trickled down to the retail level, particularly in countries that had unreliable systems for the government insurance of deposits. Ordinary depositors, seeing a major global institution go down and the financial markets gyrate, started pulling their money out of banks far from Lehman’s Manhattan headquarters. Officials were reduced to public pleas to their citizens: “Irish bank deposits are not in any danger,” announced Brian Lenihan, the Irish finance minister, on September 19. “People should not be going to their banks and making withdrawals on the basis of unfounded suggestions voiced on radio programs.”
Conference calls among the world’s central banks picked up as they worked through ways they might collectively address the burgeoning crisis. The banks’ markets chiefs—Bill Dudley of the New York Fed, Francesco Papadia at the ECB, and a half dozen counterparts around the globe—worked together to expand the strategy they had first deployed nine months earlier to address the milder form of panic spreading at that time. The calls usually happened early in the morning New York time, when it wasn’t the middle of the night in London, Frankfurt, or Tokyo. They were usually led by Dudley. After all, the central problem was a shortage of dollars—so the one institution in the world with the capability of creating dollars was in the driver’s seat.