How the crisis unfolded

The NYT takes a lengthy, behind-the-scenes look at the critical hours during the week of Sept. 15, when folks on Wall Street were panicking. We’re not talking about small-scale individual investors, but mega-billion dollar players. Turns out that the impact of the Lehman bankruptcy stoked much of the fear (a lesson, perhaps, to those who would prefer to just let Wall Street burn).

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.

What's becoming clear is how spooked the financial markets had become after a $64 billion money market fund and two smaller funds reported that they had “broken the buck” and would pay investors no more than 97 cents on the dollar. This was a very big deal because money market funds are essentially the lifeblood of commerce. They use investors’ money to make short-term loans, known as commercial paper, to big corporations.

Commercial paper is attractive to money market funds because it pays them a higher interest rate than, say, United States Treasury bills, but is still considered relatively safe. A run on money funds could force fund managers to shy away from commercial paper, fearing the loans were no longer safe. One reason given by the Reserve Primary Fund for breaking the buck was that it had bought Lehman commercial paper with a face value of $785 million that was now worth little because of its bankruptcy. If money market funds became fearful of buying commercial paper, that would make it far more difficult for companies to raise the cash needed to pay employees, for instance. At that point, it would not just be the credit markets that were frozen, but commerce itself.

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Mark Lacter
Mark Lacter created the LA Biz Observed blog in 2006. He posted until the day before his death on Nov. 13, 2013.
 
Mark Lacter, business writer and editor was 59
The multi-talented Mark Lacter
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