Understanding The Financial Crisis

“Panic can cause a prudent person to do rational things that can contribute to the failure of an institution.” — William A. Ackman of the hedge fund Pershing Square Capital Management.

In 36 Hours of Alarm and Action as Crisis Spiraled by Joe Nocera, a gaggle of New York Times financial reporters have given us a valuable look at the panic that both Wall Street and Main Street recently experienced. Their behind-the-scenes story helps explain the urgency and scope of the bailout plan that Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson proposed. Here is a brief summary of that article.

Forget the picture of depositors anxiously lining up outside a bank’s door, waiting to get their money out as soon as the bank opened for business. Nowadays, it is hedge funds pulling their money out of investment banking firms such as Morgan Stanley and Goldman Sachs. There was also a run on money market funds, a fairly recent innovation, which most investors had assumed were as safe as bank accounts.

Investors large and small had been aware of the gathering problems and the ad hoc solutions to them. And while it is somewhat difficult to identify the actual tipping point in terms of a real financial panic, it’s widely accepted that the Lehman Brothers’ bankruptcy had serious consequences. The fear was that Morgan Stanley would be next. One thing led to another, events cascading with no one in control.

Here are some relevant quotes from the article.

Up and down Wall Street, hedge funds with billions of dollars at Goldman and Morgan Stanley, another storied investment bank, were frantically pulling money out and looking for safer havens.

Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors — not small investors — were panicking the most. Nobody was sure how much damage it would cause before it ended.

This is what a credit crisis looks like. It’s not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people can’t see. It’s banks refusing to lend to other banks — even though that is one of the most essential functions of the banking system. It’s a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman — both of which reported profits even as the pressure was mounting. It is panicked hedge funds pulling out cash. It is frightened investors protecting themselves by buying credit-default swaps — a financial insurance policy against potential bankruptcy — at prices 30 times what they normally would pay.

It was this 36-hour period two weeks ago — from the morning of Wednesday, Sept. 17, to the afternoon of Thursday, Sept. 18 — that spooked policy makers by opening fissures in the worldwide financial system.

Wednesday, Sept. 17, was one of those dark, ugly market days that offers not even a glimmer of hope.

Within seconds of the market opening, the Dow was down 160 points. Among the big losers was Morgan Stanley. Despite the strong earnings it had disclosed late Tuesday, its stock continued to plummet. By noon, the Dow was down 330 points. It rallied in the afternoon, but went into free fall in the last 45 minutes, closing down 449 points.

And that was just what investors could see. Behind the scenes, the credit markets had almost completely frozen up. Banks were refusing to lend to other banks, and spreads on credit default swaps on financial stocks — the price of insuring against bankruptcy — veered into uncharted waters.

Moreover, the drain on money funds continued. By the end of business on Wednesday, institutional investors had withdrawn more than $290 billion from money market funds. In what experts call a “flight to safety,” investors were taking money out of stocks and bonds and even money market funds and buying the safest investments in the world: Treasury bills. As a result, yields on short-term Treasury bills dropped close to zero. That was almost unheard of.

In the stock market, Mr. Ehrlich of UBS was horrified by the plunge of Morgan Stanley’s shares, given the stellar earnings. “It felt like there was no ground beneath your feet,” he said. “I didn’t know where it was going to end.”

By Thursday morning, the need for dramatic action had grown even more urgent. In Asia, stocks had already closed lower. To quell fears before the opening of European markets, the Fed and other central banks announced they would make $180 billion available, in an effort to get banks to start lending to each other again. The Fed had agreed to open its discount window to make loans available to money market funds to prevent further runs.

But it was to little avail.

For a number of reasons, the administration’s original bailout plan did not pass the House of Representatives. Last night, the U.S. Senate passed a somewhat different version of the bill; now the House gets another chance.

To be continued …