Domino Effect: Understanding The Current Crisis From The Fall Of Lehman To Black Monday II

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Lehman’s bankruptcy filing in the early hours of Monday, Sept. 15, sparked a chain reaction that sent credit markets into disarray. It accelerated the downward spiral of giant U.S. insurer American International Group Inc. and precipitated losses for everyone from Norwegian pensioners to investors in the Reserve Primary Fund, a U.S. money-market mutual fund that was supposed to be as safe as cash. Within days, the chaos enveloped even Wall Street pillars Goldman Sachs Group Inc. and Morgan Stanley. Alarmed U.S. officials rushed to unveil a more systemic solution to the crisis, leading to Sunday’s agreement with congressional leaders on a $700 billion financial-markets bailout plan.

“Lehman’s Demise Triggered Cash Crunch Around Globe: Decision to Let Firm Fail Marked a Turning Point in Crisis” (subscription required), The Wall Street Journal , Monday September 29, A1

The Wall Street Journal ran a superb front page article this morning tying everything together and showing how the collapse of Lehman Brothers (LEH) triggered a domino effect culminating today in Black Monday II.

The Failure of Lehman Brothers

To understand the current unravelling, we have to go back 3 weeks to Tuesday September 9th.  On that day, news leaked that Lehman’s discussions with Korean Development Bank for an investment fell apart resulting in panic selling in Lehman shares.  The stock fell 45% on volume of 383.5 million shares – more than half of Lehman’s outstanding stock.  Lehman shares continued to get hammered for the remainder of the week on ridiculous volumes, closing Friday September 12th at $3.65 (LEH 3 Month Chart).

Heading into the weekend, many expected a deal for Lehman to be completed by Monday.  However, the Federal Reserve refused to backstop any of Lehman’s toxic debt the way they had when JP Morgan acquired Bear Stearns and absent that potential suitors such as Bank of America and Barclays PLC walked away.  Very late Sunday night September 14th, Lehman Brothers filed for bankruptcy.

When markets opened for business the morning of Monday September 15th it was financial armageddon.  The Dow ultimately fell 504 points – the worst day since markets opened after the September 11, 2001 attacks. 

AIG Becomes the 1st Domino

One consequence was a surge in the prices for credit default swaps (CDS).  CDS contracts represent insurance against bond defaults by corporations and other kinds of securities, including mortgage backed securities.

One of the biggest writers of CDS was insurance behemoth American International Group (AIG).  The surge in the price of CDS on Monday meant that AIG had to post far more collateral against the CDS contracts it had written.  Shares of AIG fell 61% on Monday.

As if that wasn’t enough, Fitch downgraded AIG’s credit rating Monday evening followed by Moody’s and S&P.  This also required AIG to post more collateral against its outstanding debt. 

AIG found itself in a massive cash crunch.  Shares fell another 21% on Tuesday on massive volume as AIG scrambled to line up a loan or equity investment. 

Unable to secure private financing and facing the collapse of a giant insurance company with its tentacles interwoven throughout the entire global financial system, the Federal Reserve stepped in Tuesday night with an $85 billion loan to AIG at a usorious interest rate and in exchange for warrants representing a 79.9% stake in the company (Fed AIG Press Release).

The Reserve Primary Fund “Breaks The Buck”

The collapse of Lehman also had an unforeseen effect on what has long been considered one of the safest investment vehicles: money market mutual funds.  One of the oldest and most respected money market mutual funds, The Reserve Primary Fund, had $785 billion face value of Lehman commercial paper.  Tuesday evening the fund announced that due to its Lehman holdings it had “broken the buck” – the first time that had happened in 14 years.

This announcement caused a major shakeup in the money market and commercial paper markets on Wednesday.  Investors rushed to redeem their money market holdings, pulling a record $89 billion that day, while money market managers sold commercial paper with abandon and rushed into short term government debt (Money Funds Shun Commerical Paper Chart), pushing the yield on the 3-month T-bill negative at one point Wednesday.

Many corporations rely on selling commercial paper to money market funds, which have about $3.5 trillion under management, to fund their operations.  With the panic, money market funds weren’t interested in buying much commercial paper and the market completely dried up, threatening companies with signficant operations in the real economy.

Fear Envelops Goldman Sachs And Morgan Stanley

At the same time AIG was on the verge of going under and the commercial paper market had frozen, the investment community was focused on the fate of the two remaining independent invesment banks, Morgan Stanley (MS) and Goldman Sachs (GS).  Investors worried about their reliance on the commerical paper market and other forms of short term financing.  If they couldn’t roll over short term financing that came due, they’d have to sell assets at fire sale prices potentially resulting in bankruptcy.  CDS prices on their debt surged and hedge fund clients pulled assets from their prime brokerage units.  Their stocks sold of mercilessly.

The $700 Billion Solution

At this point, Fed Chairman Bernanke and Treasury Secretary Paulson had seen enough.  They set up meetings with the President and key members of Congress on Thursday to brief them on a bailout plan that would involve using government money to buy the toxic mortgage assets that were crippling the nation’s financial institutions. 

Wind of this leaked Thursday afternoon and the Dow gained almost 1000 points and the S&P more than 100 points Thursday afternoon and Friday.

WaMu Becomes The Largest Bank Failure In US History

Last week, as Paulson and Bernanke testified before Congress and Republicans and Democrats tried to put together a bill they could pass, all across the country scared depositors were pulling money from banks.  A run at Washington Mutual (WM), which resulted in the withdrawal of $16.7 billion in deposits from Monday September 15th through Thursday September 25th, forced the OTS to seize the bank Thursday night in the biggest bank failure in US history.

Black Monday II

Markets held up Friday on the expectation that Congress would have a bill ready by Monday that would pass.  A number of banks, notably Wachovia (WB) and National City (NCC), saw their shares hammered on fears that they might also be experiencing runs on their deposit bases.  But overall the tone was positive.

This afternoon, the failure of the House of Representatives to pass the bailout bill everyone thought would pass resulted in Black Monday II, a 107 point, 8.79%, selloff in the S&P 500 – the worst day since the Crash of 1987.

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