Saxton was on to something. The IMF had viable alternatives to avoid going broke—and as Geithner’s memo showed, the Clinton administration was prepared to use them if necessary, although doing so would have incurred some political and economic costs.
The memo listed several options that “could be used in combination with each other.” The IMF could indeed sell some of its gold, although that was probably the worst idea for raising money, according to Geithner, because “the more this option is exercised, the greater the effect on gold prices, the less return on sales.” He gave low marks to another idea, having the IMF borrow money on private financial markets, because it would dilute member countries’ control over Fund policies.
But the memo was less negative about other possibilities. Maybe $10 billion more could be squeezed out of the IMF’s cash on hand, Geithner wrote. Since Treasury and IMF officials had loudly insisted that the Fund needed to maintain a $30 billion to $35 billion reserve cushion, using that money for loans would presumably require “some understanding among countries” to refrain from exercising their right to withdraw their contributions. Or perhaps the Fund could borrow on a bilateral basis from Japan, Germany, or the BIS. Although the lenders “would almost certainly exact a price,” the Fund had engaged in such borrowing in the past when its resources were low, Geithner noted.
Much sound and fury accompanied the congressional debate about IMF funding in 1998. But although proponents were understandably anxious to see the legislation pass, the prospect of the Fund running completely dry was remote. The High Command had much more stress-inducing issues with which to contend.
For market players like David Tepper, August-early September 1998 was a time for getting out of the markets while the getting was good. Balding and mustachioed, Tepper ran a hedge fund called Appaloosa Management from a nondescript brick building in Short Hills, New Jersey, about forty-five minutes from Manhattan. The firm was one of the biggest in the hedge-fund business, with about $1.5 billion in investors’ money, thanks to Tepper’s reputation for spotting trends quickly. When Russia announced its default and devaluation on August 17, Tepper recalled in his staccato New Yorkese, “I knew you couldn’t screw around.” So in the days immediately following Russia’s move, the forty-year-old Tepper ordered his traders to begin drastically trimming Appaloosa’s portfolio, especially emerging-market bonds and U.S. corporate bonds.
“The problem was, you had had this idea that with the IMF, there was some safety net underneath the market,” Tepper said, “but if Russia could default, why couldn’t Brazil default, and why couldn’t Mexico default, and why couldn’t others default?” And if those countries’ bonds were going to fall because of default worries, the same seemed likely to happen to, say, the double-B-rated bond of a U.S. company that has to offer a yield sufficiently attractive to compete with the likes of Mexican and Brazilian bonds for investors’ favor. “If you’re doing portfolio management, and there’s a 25 percent probability something’s going to [negatively] affect the price of something you hold, you sell. No matter what,” Tepper declared. “I don’t give a shit if it’s affected or not at the end of the day. It’s Just a probability game. So we moved pretty fast in August.”
Tepper’s reaction was shared by thousands of people who trade bonds on Wall Street and other financial centers, which explains why the bond market in the United States “seized up” in fall 1998 like an auto engine that has run out of oil, and very nearly created the conditions that would have forced the American economic expansion to a halt. The stock market’s woes during this period were obvious and well-publicized, but policymakers like Rubin, Greenspan, and Summers weren’t concerned much with falling share prices. Their major worry was the bond market.
The bond market is where, in today’s world, most U.S. companies of any appreciable size borrow the bulk of the cash they need to run their operations day to day and year to year. They issue short-term commercial paper, maturing in two or three months, to pay their workers and suppliers while awaiting payment from customers. They issue longer-term notes and bonds to finance the purchase of new equipment or the construction of factories. They can borrow from banks, too, of course, and many do. But over the past couple of decades, a shrinking portion of the corporate loans provided in the United States has come from banks. Even mortgage loans, though handled by banks initially, are usually financed by bond investors who buy the rights to receive large batches of mortgage payments from homeowners and property owners. Some 70 to 80 percent of all corporate and mortgage lending is now funneled through the capital markets, which generally offer cheaper rates. So when investors refuse to buy all but the super-safest of bonds, as they did in autumn 1998, the consequences can be Just as ominous for Main Street as for Wall Street.
Bonds are normally conservative, almost boring investments, rising and falling only modestly in price. A bond, after all, is supposed to provide a guaranteed stream of interest and principal payments, unlike a share of corporate stock, which provides returns that vary depending on the company’s earnings or expectations thereof. To be sure, some bonds—Russian GKOs, for instance—are far from conservative, and their prices soar and plunge in tandem with fears about whether the issuer can make the payments due. But most bonds, issued by countries and companies for which nonpayment isn’t much of a concern, rise and fall mainly because of changes in prevailing interest rates.
For a simple example, consider a $1,000 bond issued by a relatively solid U.S. company with a 10 percent coupon (that is, paying $100 in interest each year). It would become less valuable—and would fall concomitantly in price—if interest rates went up a couple of percentage points, because bonds with similar maturities, from issuers of similar creditworthiness, would become available with yields of 12 percent (that is, paying $120 on each $1,000 invested). Conversely, the bond would become more valuable—and would rise concomitantly in price—if interest rates fell a couple of percentage points, because it would compete with similar bonds coming on the market with coupons of only 8 percent. This illustration should help explain why the business pages of newspapers often tell readers that “bond prices move inversely with interest rates.” And it should help explain why the bond market typically fluctuates much less than the stock market—because interest rates are the main influence, and they tend to rise and fall gradually.
But all these dynamics spun totally out of whack in August, September, and October of 1998, which an IMF report would later describe as “a period of turmoil in mature markets that is virtually without precedent in the absence of a major inflationary or economic shock.” The result was a near standstill in the issuance of many types of bonds, crunching credit dangerously tight.
Smack in the midst of the upheaval was the trading room of Salomon Smith Barney, a cavernous, windowless chamber on the forty-second floor of a downtown Manhattan office tower where about 400 men and women worked at long rows of desks with flashing computer monitors, yakking over the phone about “crossover paper” and “stripped-spread Brady’s” and “Treasury bond arb positions.” Salomon ranked among the largest of Wall Street’s broker-dealers; it was a major intermediary between banks, insurance companies, hedge funds, mutual funds, pension funds—Just about any institution looking to buy or sell a few million dollars worth of bonds, stocks, currencies, options, interest-rate swaps, or other financial instruments. The firm’s profitability depended on the ability of its traders and salespeople to gauge the appetite among institutional investors for these securities, and in autumn 1998, the appetite for bonds—with the notable exception of U.S. Treasuries—dwindled to virtual nothingness.
Among the people on that trading floor was John Purcell, a managing director in Salomon’s bond trading operation, whose recollections provide insight into the process by which Russia, a country with only about 1 percent of the world’s GDP, exerted such a profound impact on markets. The dapper Purcell, who earned a master’s degree in economics from Ohio University in 1984, was fluent in trader
Jargon. But in explaining what happened that autumn, he often reverted to the simple language of gut feelings as he recounted a chain of events involving linkages and interactions among different types of securities, firms, and markets that nobody anticipated—either in the markets or in the High Command. “Russia from an economic standpoint was not very significant, but it affected the psyche of investors fairly substantially, because a lot of the things they believed in sort of fell apart,” said Purcell. “There was a very visceral and emotional element to this.”
One factor that initially confounded Western portfolio managers after August 17, he said, was a step the Russian government took that canceled foreign-exchange contracts they had with Russian banks. The contracts were supposed to protect foreign investors in Russia against a fall in the ruble by ensuring that they could exchange their rubles for dollars at the old fixed rate. But Moscow essentially invalidated those deals, on the grounds that the country’s banking system would collapse if the banks were forced to fulfill their obligations. “So that’s problem number one: Investors thought they had a hedged trade, but guess what? They don’t have a hedged trade anymore,” Purcell said. “Suddenly they realize they’re standing in midair. Things they thought couldn’t happen are happening, like defaults on local currency debt.”
Also staggering was the scale of losses on some Russian bonds, which fell in price by 30 percent or more in a matter of days, followed by the bonds of other emerging-market countries whose creditworthiness was now in more serious doubt. “In the old days, if a bond went down 10 to 15 points, that was pretty bad, but it might only happen in one or two instances. Now whole asset classes were going down 20 and 30 points,” Purcell said. “You’re an insurance company or money manager, and you Just had a piece of your portfolio—not a big piece, but a piece—blow up. It’s one thing when that happens in isolation, but now it’s happening in a whole bunch of different places.”
Severe losses would have been manageable, except that many of the investors in securities like GKOs and Russian Eurobonds, especially hedge funds, had borrowed heavily to finance their purchases. This sort of leveraged investing is widespread in the bond markets; an investment firm can increase its overall return because the yield on its bonds almost always exceeds the interest on its loan. Alas, the catch is that its bonds are pledged as collateral—and when their value plummets, margin calls come from creditors demanding repayment.
Salomon had lent substantial sums to hedge funds, so it was compelled to place margin calls to them. Other financial firms were doing the same, and that is how a sell-off of “bad” bonds begat a sell-off of “good” bonds. Investors hit with margin calls were compelled to unload higher-quality issues to satisfy their creditors’ claims, and when the higher-quality paper came under selling pressure too, the urge to cut and run grew even more intense.
A phobia of risk pervaded the markets, most clearly evinced by the widening “spread” between the yields on U.S. Treasury bonds and other types of bonds. Treasuries are regarded as the safest investment in the world, because the chance that the U.S. government would fail to pay interest or principal is as near to zero as conceivably possible. So the spread between Treasury yields and yields on other bonds is a classic measurement of how cautious investors are being—that is, the amount of extra return they require as compensation for the danger of default. The wider a bond’s spread, the greater the market’s concern about its riskiness.
By mid-September 1998, the spread on “Junk” bonds—bonds issued by American companies with relatively low credit ratings—reached nearly 6 percentage points above comparable U.S. Treasuries, up from about 2.75 percentage points at the end of 1997. The spreads on Mexican and Korean bonds roughly doubled, to about 10 percentage points above Treasury yields, and the average spread for all emerging market bonds widened to more than 17 percentage points. The result of this widening of spreads, and surge in yields, was that it became prohibitively expensive for most companies and governments to consider raising money in the bond market because of the interest cost they would have to pay.
But rising spreads and interest costs were only part of the problems that were causing bond markets to reach a state of disfunctionality.
Around Labor Day, a mutual-fund manager called Salomon wanting to sell $50 million of thirty-year bonds issued by a major telecommunications company. Ordinarily, such a transaction would be a matter of routine, because those particular bonds were widely traded—indeed, they were a benchmark for much of the corporate bond market—and the mutual-fund manager wanted to get Salomon’s bid for the bonds so he could compare it with bids from three or four other broker-dealers. But besides Salomon, nobody else would bid.
In other words, gridlock was setting in—or, as traders and economists put it, illiquidity. The market lacked the lubrication that comes with many intermediaries standing ready to buy and sell. Broker-dealers were much more reluctant than before to take bonds off investors’ hands, unless they were reasonably sure they had another customer lined up to buy them. To the extent they were willing to trade at all, they insisted on prices that were much more advantageous to themselves. Trading shriveled as a result, and investors confronted the depressing reality that the numbers flashing on their computer screens almost certainly understated the losses they would suffer if they tried to sell their holdings.
Perhaps most disturbing was what was happening to U.S. Treasuries. Because they are backed by the full faith and credit of the United States, Treasuries are almost invariably snapped up by the billions of dollars during crises of all sorts, as investors engage in a “flight to quality” while shunning riskier issues. That was true during autumn 1998 as well but to an alarming extreme. Investors were so spooked by the illiquidity in the markets that they were putting a premium on particular types of Treasury bonds that could be sold with the greatest ease and speed, in case they needed to raise cash in a hurry.
Heather Neale, a trader who worked with Purcell, punched a few keys on a computer to bring up a row of numbers showing the prices and yields on a recently issued thirty-year Treasury bond. This is an “on-the-run” bond, so called because having Just been issued, it’s being actively traded. Then Neale punched a couple of other keys to bring up similar numbers for a thirty-year Treasury issued a couple of years earlier. This is an “off-the-run” bond, which no longer trades much because investors have salted it away in their portfolios. As expected, the prices of these two bonds had adjusted so that the difference in yield (the spread) between them was minuscule—it’s normally about five to seven “basis points” (a basis point is one onehundredth of a percentage point). After all, investors buying a bond backed by the U.S. government aren’t likely to care much whether it matures in twenty-eight years or thirty years.
But in autumn 1998, investors did care. “If you get a chart comparing spreads in on-the-run and off-the-run, you’ll see they exploded,” Neale said. Specifically, the spread widened to 35 basis points in October 1998. Put another way, investors at that time were willing to sacrifice about a third of a percentage point in yield to buy a highly liquid thirty-year Treasury instead of a less liquid one. That may not seem significant, but in the world of bond markets, it signaled an intense fear of holding anything that couldn’t be dumped immediately.
Unsurprisingly, considering the mood among money managers, “Guys on the floor were telling me, at the beginning of October, that there wouldn’t be any bonds sold [that is, issued by corporations] until the end of the year,” said Jeffrey Shafer, a senior Salomon executive. In fact, the amount of high-yield corporate bonds issued in U.S. markets fell in October 1998 by about 85 percent from the monthly average of the previous spring.
Purcell provided this encapsulation of the atmosphere in the markets:There’s a huge flight to quality, because money managers might need to raise cash in the event of withdrawals. So what’s your willingness to commit any money to the market? Zero. Who wants to buy a new corporate bond when all your analysts are too
busy investigating the blowups you’ve already got in your portfolio?
You’re trying to figure out, what does anything mean anymore on this planet? All the relationships [between bonds] that we knew about are suddenly meaningless. And you don’t have a lot of confidence in the whole global economic picture. You’re thinking, things could really spiral out of control.
11
PLUMBING THE DEPTHS
As the executive vice president heading the markets group at the New York Fed, Peter Fisher held chief responsibility at the U.S. central bank for overseeing and monitoring the health of the nation’s financial markets. Six-foot-three, with a graying crown of thick, curly hair and horn-rimmed glasses, he was the son of Roger Fisher, a retired Harvard Law School professor and author of a bestseller about negotiating tactics called Getting to Yes. A lawyer by training who had spent his entire career at the New York Fed, Peter Fisher had a pleasant sense of whimsy, as evidenced by a practice he instituted concerning the timing of the Fed’s daily interventions in the financial markets. The New York Fed’s trading desk used to contact Wall Street bond traders at exactly the same time every morning to purchase or sell large amounts of Treasury bills—a closely-watched operation, eagerly awaited on the Street, by which the central bank regulates the nation’s money supply and influences the level of interest rates. Shortly after being promoted to the executive vice president’s Job, Fisher decreed that each weekday a little after 10 A.M., a New York Fed staffer would shake a single die in a leather cup and roll it onto the table—the number, one to six, determining the number of minutes after 10:30 that the Fed would contact the bond dealers. He described the exercise as part of his effort to achieve “maximum flexibility.”
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