Thursday, October 2, 2008

36 Hours of Alarm and Action as Crisis Spiraled

But in their urgency, they bypassed a crucial step in Washington and fashioned their $700 billion bailout without political spadework, which led to a resounding rejection this past Monday in the House of Representatives. .... Hedge Fund Accounts Locked Up But contagion was already spreading. The problem posed by the Lehman bankruptcy was not the losses suffered by hedge funds and other investors who traded stocks or bonds with the firms. As federal officials had predicted, that turned out to be manageable. (That was one reason the government did not step in to save the firm.) The real problem was that a handful of hedge funds that used the firm’s London office to handle their trades had billions of dollars in balances frozen in the bankruptcy. Diamondback Capital Management, for instance, a $3 billion hedge fund, told its investors that 14.9 percent of its assets were locked up in the Lehman bankruptcy — money it could not extract. A number of other hedge funds were in the same predicament. (When called for comment, Diamondback officials did not respond.) As this news spread, every other hedge fund manager had to worry about whether the balances they had at other Wall Street firms might suffer a similar fate. And Morgan Stanley and Goldman Sachs were the two biggest firms left that served this back-office role. That is why Mr. Ackman’s investors were calling him. And that is what caused hedge funds to pull money out of Morgan Stanley and Goldman Sachs, hedge their exposure by buying credit-default swaps that would cover losses if either firm couldn’t pay money they owed — or do both. ....Break the buck There was another piece of bad news spooking investors — and government officials. On Tuesday, the Reserve Primary Fund, a $64 billion money market fund, and two smaller, related funds, revealed that they had “broken the buck” and would pay investors no more than 97 cents on the dollar. “Breaking the buck was the Rubicon,” said a federal official. “This was the first time in the crisis that you could see stories talking about how it was affecting real people.” Since that Monday, big institutional investors — like pension funds and college endowments — had been pulling money out of money funds. On Tuesday, individual investors joined the stampede. The Fed Takes Action Ben Bernanke had spent his career studying financial crises. His first important work as an economist had been a study of the events that led to the Great Depression. Along with several economists, he came up with a phrase, “the financial accelerator,” which described how deteriorating market conditions could speed until they became unmanageable. To an alarming degree, the credit crisis had played out as his academic work predicted. But his research also led Mr. Bernanke to the view that “situations where crises have really spiraled out of control are where the central bank has been on the sideline,” according to Mark Gertler, a New York University economist who has collaborated with Mr. Bernanke on some papers.

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