What Happened Last Week? from Randall Forsyth at Barron's

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MONDAY, SEPTEMBER 22, 2008
CURRENT YIELD



Credit Where Credit Is Due
By RANDALL W. FORSYTH

When credit collapses, nothing else can stand.


CREDIT COUNTS. IF YOU don't believe it now, you never will.

While multi-hundred-point gyrations in the Dow grabbed the media headlines, credit borrowing and lending -- the basic functions of finance, on which the real economy of producing, buying and selling depend to function from day to day -- came close to breaking down.

Nothing compares with what's happened in the past fortnight.

The government bailout of Fannie Mae and Freddie Mac, as announced Sunday, Sept. 7, was no surprise. It had been foretold on another balmy Sunday evening in mid-July, and became inevitable as the government-sponsored enterprises' ability to finance themselves was called into question.

But the Treasury bailout of Fannie and Freddie failed to stop the downward spiral. The following Sunday, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke declined to help fund a takeover of Lehman Brothers, as the central bank had done with JPMorgan Chase's acquisition of Bear Stearns in March. Lehman was left with no choice but to file for bankruptcy the following day.

Faced with the possibility it could meet a similar fate, Merrill Lynch rushed to merge with Bank of America. The Thundering Herd had always been fiercely independent, unlike Lehman or Morgan Stanley. (Remember their respective divorces from American Express and Dean Witter?) But getting $29 a share was a lot better than the $10 Bear got, and the zip Lehman received. Yet the prospect of failure by American International Group posed a bigger risk. AIG has a monstrous $1 trillion balance sheet and its "tentacles" were everywhere, as New York Gov. David Paterson characterized the reach of the nation's largest insurer.

Tuesday afternoon, the Federal Open Market Committee opted to hold its key target rate for federal funds unchanged, at 2%, confounding expectations of a cut by Fed watchers and the futures market. The reasoning would become apparent that evening. The central bank decided to provide a massive $85 billion loan to AIG at stringent terms, and an equity stake of 79.9%, the same as Treasury got for bailing out Fannie and Freddie.

But even that didn't calm the markets. Strains worsened after a major money market fund "broke the buck" -- that is, saw its share price fall below the sacrosanct $1.00-a-share level -- and suspended redemptions.

This was the result of unintended (but foreseeable) consequences. The money fund held Lehman paper, which it wrote down to zero, knocking its NAV to 97 cents. Holders, who had assumed they would always get a dollar out for every dollar they put in, bolted for the exits. This was especially the case of institutional money funds, which yanked $173 billion out in the week ended Wednesday, most of it that day. Instead, these investors fled for the safety of T-bills, sending their yields to virtually nil.

The tide ultimately was turned Thursday afternoon, after news reports indicated Washington was cooking up a massive scheme: A plan recalling the Resolution Trust Corp., which worked out the savings-and-loan failures of the late 1980s and 1990s, was in the works.

By Friday morning, it was official. Treasury Secretary Paulson announced that the plan would involve "hundreds of billions" of taxpayers' dollars to buy up bad assets.

In addition, the Treasury would provide insurance for money funds analogous to FDIC backing for bank deposits. That was aimed at stopping the modern-day bank run on the money funds and thus alleviating the strains on the money market. The Fed, for its part, also instituted an array of new lending facilities to stop the crunch. And, the SEC called a halt to short sales of financial stocks. That came in reaction to the wholesale selling of icons such as Goldman Sachs and Morgan Stanley. But their credit default swaps-derivatives insuring the credits of the investment banks-cratered to levels that implied imminent bankruptcy. Sellers of credit protection hedged their position by shorting the stock. The resulting plunge in the stock further tightened the credit vise.

The government's actions does help address the liquidity crisis, for now. Stocks soared Thursday and Friday, and the strains in money markets eased. But the crux of the crisis remains. Lenders can't lend while they're laden with underwater, illiquid assets and can't raise capital.

The government may have put out the fire. The rebuilding lies ahead.