How a panicky day led the Fed to act

Freezing of Credit
Drives Sudden Shift;
Shoving to Make Trades

By Randall Smith, Carrick Mollenkamp, Joellen Perry, and Grep Ip
The Wall Street Journal
Monday, August 20, 2007

Strains in financial markets had been evident for weeks, but Thursday, Aug. 16, was different.

As the day dawned in London, $45.5 billion in short-term IOUs issued outside the U.S. by corporations and others were maturing and had to be rolled over. Traders usually have buyers for such paper by lunchtime in London, around 7 a.m. in New York. On this morning, demand had dried up, and it would take the whole day to sell less than half of it, said a person familiar with the market.

At 7:30 a.m. in New York, the largest maker of mortgages in the U.S., Countrywide Financial Corp., said it was tapping $11.5 billion in bank credit lines, a sign that it was unable to raise money in financial markets as it had been.

This was a development more serious than another hedge fund running into trouble. "When you start talking about Countrywide," said one senior Wall Street executive, "that's kind of America. At the end of the day, we're talking about Mom and Pop and the right to own a home."

Just before noon New York time, near the end of the London trading day, the yen suddenly surged against the dollar, rising 2% in just minutes and crushing currency-market players who hadn't anticipated such a sharp move. On the London trading floor of Goldman Sachs Group Inc., phone lines lit up in unison, and some salesmen wielded two phones at the same time. They were shoving and grabbing each other to get in front of traders, and shouting orders to execute trades, according to eyewitnesses.

Shortly afterwards, investors began piling into the shortest-term U.S. Treasury securities, which are considered safe because they're backed by the U.S. government. The yield on three-month bills, which had been around 4%, dropped as low as 3.4%, and the gap between yields on T-bills and corporate commercial paper widened sharply. "It was an extraordinarily violent move," said Jason Evans, head of government-bond trading at Deutsche Bank. "It became clear that the market was at a point of distress and expected a response" from the U.S. Federal Reserve.

These shocks reflected one of the most perilous days for global credit markets, the circulatory system of the international economy, since the 1997-98 crisis that began in Asia, spread to Russia and Brazil and eventually to the U.S.-based hedge fund Long-Term Capital Management.

On Friday morning, following a conference call the previous evening convened by Chairman Ben Bernanke, the Fed blinked. Just 10 days after declaring that inflation was still its predominant worry, the Fed declared "downside risks to growth have increased appreciably" and hinted that it may soon cut its target for short-term rates. In an unusual move, it also encouraged banks to borrow directly from the Fed and made such loans more attractive.

In essence, the Fed is following advice that British journalist Walter Bagehot offered in his 1873 book, "Lombard Street," a copy of which Mr. Bernanke kept on a shelf when he was Princeton professor. In times of "internal discredit" -- when uncertainty leads private players to pull back -- the prescription to the central bank is: Lend freely.

"A panic...is a species of neuralgia, and according to the rules of science you must not starve it," Bagehot wrote. "The holders of the cash reserve" -- today's central banks -- "must be ready...to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to 'this man and that man,' whenever the security is good."

...Bolstering Confidence

This week, the Fed will find out if it did enough to bolster the confidence that was in such short supply last week, when investors refused to buy or accept as collateral securities that in normal times would be of unquestioned worth. Its critics, including those who say it is too quick to rescue imprudent lenders and borrowers, will be watching for evidence that the Fed went too far.

The initial reaction of U.S. stock and credit markets to Friday's Fed move was favorable. The interest-rate spread between U.S. government bonds and some riskier bonds shrank slightly, while the Dow Jones Industrial Average rose 1.8%. In early Tokyo trading today, stocks surged more than 3%.

It isn't clear yet how many big banks responded to the Fed's encouragement to borrow at what is known as the Fed's discount window. Hard data won't come until the Fed releases its routine tally on Thursday -- unless the Fed or the banks volunteer information. One big bank told the Fed that, though it doesn't need the money and could get it more cheaply, it will borrow $100 million today as a gesture, according to a person familiar with the bank's plans. And one Wall Street firm said it planned to offer collateral to its bank, assuming the bank in turn would offer it to the Fed as collateral for a discount-window loan.

The latest chapter in the credit crisis of 2007, rooted in the deterioration of the market for U.S. subprime mortgages and securities linked to them, represents a new test of the savvy of central banks from Frankfurt to London to Washington to Tokyo. These are the institutions in modern capitalist economies that regulate the supply of credit with the goal of keeping prices from rising too fast and preventing economic downturns from deteriorating into repeats of the Great Depression.

It began on Tuesday, Aug. 7, in Europe. Shortly after 9 a.m., on the second floor of the European Central Bank's 37-story glass and metal office tower in Frankfurt, the bank doled out €292.5 billion in its regular weekly financing operation. Commercial banks were flush with cash, yet money-market rates -- the interest charged by banks when lending to one another -- were rising. Something was eroding the banks' willingness to lend.

On Wednesday, the ECB noticed volatility increasing and credit spreads rising. More money was flowing into safe havens such as two-year German government bonds, and reports of tensions in the commercial-paper market were circulating. By evening, it was clear the ECB had to intervene to keep market rates from rising well above the central bank's previously set target of 4%. President Jean-Claude Trichet and Vice President Lucas Papademos were in touch with Fed officials.

With market rates nearly three-quarters of a percentage point above the target, ECB staffers charged with monitoring liquidity met at 8:45 the next morning, about 90 minutes earlier than usual, says a person familiar with the matter. They recommended that the central bank take the biggest move in its nine-year history -- an unlimited offer of funds to the banking system at its 4% target rate. Members of the Executive Board approved the decision.

At 10:26 Frankfurt time, screens across the world flashed the message: "The ECB notes that there are tensions in the euro money market notwithstanding the normal supply of aggregate euro liquidity. The ECB is closely monitoring the situation and stands ready to act to assure orderly conditions in the euro money market." At 12:32 p.m., the ECB announced that it would accept all bids to borrow money made by 1:05 pm.

The announcement sent shock waves through the market. At 2 pm, the ECB said it was lending E94.8 billion in one-day funds, bigger even than its initial reaction to the Sept. 11, 2001, terrorist attacks. That night, JP Morgan's senior European economist, David Mackie, said, "For the last few days, people have been worried that [the subprime crisis] would translate to a broader liquidity issue. I think the surprise is that it happened in Europe, rather than in the U.S."

In the days that followed, the ECB repeatedly put money into the markets. To a lesser degree, so did the Fed and other central banks. On Friday, Aug. 10, following an early-morning conference call among Fed policy makers, the Fed assured the markets that it would do what was necessary to keep the economy lubricated with cash. By Tuesday, Aug. 14, Mr. Trichet, who was in and out of Frankfurt while trying to take a vacation, issued a statement saying that conditions in the euro zone had gone "progressively back to normal."

But that would prove overly optimistic.

On Wednesday, a real-estate affiliate of Wall Street buyout titan Kohlberg Kravis Roberts & Co. asked investors to accept a six-month delay in repayment on $5 billion in commercial paper.

That night, Countrywide notified banks that it was going to draw on its prearranged credit lines, a move hastened by a Merrill Lynch analyst's warning that Countrywide could face bankruptcy. Countrywide bonds plunged, and the price of insurance against a default soared. At one point Thursday morning, it cost $1.1 million per year to buy protection for every $10 million in Countrywide debt.

Countrywide's woes posed a particularly severe risk to the economy, officials in Washington realized. It is a major force in the market for jumbo mortgages, those greater than $417,000. By law, the government-sponsored mortgage investors Fannie Mae and Freddie Mac cannot buy these big mortgages.

Markets overseas were going haywire too. Until the credit crunch, many investors had engaged in the so-called carry trade, borrowing money in Japanese yen, a low-yielding currency, and converting the yen to higher-yielding currencies such as the U.S. dollar and the Australian dollar. Now, facing big losses, some investors needed to unwind these trades, and the yen shot up in value. So many traders were trying to unload the Australian currency that Australia's central bank intervened to restore order for the first time in six years.

In Canada, a group of banks and investors had to rescue faltering issuers of 130 billion Canadian dollars (US$121 billion) in commercial paper.

On Thursday, a top Wall Street executive telephoned Rob Nichols, a former Treasury official who is now president of the Financial Services Forum, a Washington trade group, asking for help in conveying to the Fed the urgency of the deteriorating situation. "It is time for us to act," he said. Mr. Nichols passed on the information, but found the Fed already knew it.

Fed Chairman Bernanke, sometimes derided on Wall Street for being an academic rather than a market veteran, had long studied episodes like this. In a January speech, he noted that the Fed was founded "in response to the periodic episodes of banking panics and other forms of financial instability that had plagued the U.S. economy during the 19th and early 20th centuries." These panics typically started when banks faced a sudden drain on their deposits and called in loans to meet those demands, fueling a self-reinforcing constriction of credit.

...Discount Window

In the Panic of 1907, the stock market crashed, the U.S. slid into recession and bank runs broke out across the country. Famed financier J.P. Morgan organized other bankers to direct credit to troubled banks, secure international lines of credit and buy stock, and calm was restored. After the Federal Reserve was founded in 1913, banks were able to access the discount window, the same mechanism the Fed is now using to stimulate a willingness to lend.

Over the past few weeks, Wall Street executives peppered Fed officials in New York and Washington with suggestions for easing the logjam in credit markets. One idea was for the Fed to widen the type of assets it accepts in its "open-market operations," when it pumps cash into the economy by buying U.S. government bonds and the like. Some thought the Fed should buy lower-quality mortgages.

At one point on Thursday, three big banks -- J.P. Morgan Chase & Co., Citigroup Inc., and Bank of America Corp. -- discussed with the Fed the possibility of borrowing a total of $75 billion to be used to buy asset-backed commercial paper, mortgage-backed securities, and other instruments.

Fed officials say they welcomed the creativity. They listened to some ideas without comment, and in some cases explained that the suggestions were outside the Fed's normal legal authority.

For several days, Mr. Bernanke pondered options with his confidants. They included the Fed's vice chairman, Donald Kohn, an economist who was one of former Chairman Alan Greenspan's closest aides; and Timothy Geithner, president of the New York Federal Reserve Bank and a protégé of former Treasury secretaries Robert Rubin and Lawrence Summers. The officials were looking for a maneuver dramatic enough to shore up confidence, while avoiding a cut in the Fed's main interest rate, the federal-funds rate. Mr. Bernanke was still not convinced the economy needed a cut, and some Fed officials feared it might encourage more of the sloppy lending that led to the crisis.

They began to look more closely at the discount window. Banks remain well-capitalized and profitable. But they appeared reluctant to provide credit to companies, issuers of commercial paper and even each other, perhaps out of uncertainty over the safety of their customers or their collateral.

Eventually, Fed officials agreed to reduce the rate charged on loans from the discount window (to 5.75% from 6.25%) and try to reduce the usual stigma associated with such loans. By making these direct loans to banks more attractive, the Fed hoped to reassure banks that they could borrow if they needed to -- without the usual penalty to their bottom line or to their reputation -- and thus make them a bit more willing to lend in normal fashion.

In addition, in its public statement Friday morning, the Fed made what amounts to a vow to cut its target on the federal-funds interest rate if normalcy fails to return. That is the key rate that the Fed normally lowers when it wants to loosen monetary policy. The Fed believed this combination of moves would assure everyone that it was aware of risks to the U.S. economy posed by the market turmoil.

Particularly at times of stress, what the Fed says can be almost as powerful a weapon as what the Fed does. So Mr. Geithner, whose job makes him the traditional liaison to Wall Street, turned to a convenient forum, the Clearing House Payments Co., which is owned by a group of banks and operates much of the plumbing of the nation's financial system. To avoid the inevitable headlines -- and comparisons to the 1998 rescue of Long-Term Capital Management, when financial executives were summoned to the New York Fed's fortress-like headquarters -- Mr. Geithner sought a 15-minute telephone conference call.

On the call were commercial bankers who work with Clearing House as well as several top investment bankers, among them Zoe Cruz, co-president of Morgan Stanley; James Cayne, chief executive of Bear Stearns Cos.; Joseph Gregory, president of Lehman Brothers Holdings Inc.; and Stan O'Neal, chief executive of Merrill Lynch & Co.

...Sign of Strength

Joined by Mr. Kohn, but not Mr. Bernanke, Mr. Geithner told banks about the discount-rate cut and said they could wait up to 30 days, instead of just a day, to pay back their discount-window loans. "We will consider appropriate use of the discount window ... a sign of strength," said Mr. Geithner, according to a participant.

Seth Waugh, chief executive of Deutsche Bank AG's Americas unit, told those on the call that it was important for discount-window borrowing not to be seen as a sign of financial weakness. "You need some safety in numbers," Mr. Waugh said, according to a person who was listening. He said the Fed needed to make clear it "will be there for as long as it takes to restore liquidity."

Another banker participating in the call said of the Fed, "What they came up with is pretty ingenious." Investment banks or hedge funds that hold mortgage-backed securities can't borrow from the Fed directly, but they can bring those securities to banks. In turn, the banks can offer the paper as collateral to the Fed for a 30-day loan.

The Fed "really wanted to drive home the point that if [bankers] were complaining about not being able to borrow money against liquid, high-quality securities -- mortgages -- we have no more basis for complaint. We were all given a clear message," says this banker.

Bond markets on Friday were calmer, although not completely won over by the Fed's move. The price of two-year and 10-year Treasury bonds fell slightly, suggesting demand for these safe investments wasn't as great as before, although the price of three-month Treasury bills rose. The difference between yields on junk bonds and Treasury bonds slipped to 4.48 percentage points, from 4.59 percentage points on Thursday, according to a Merrill Lynch index, in a hint that tolerance for risk was recovering somewhat.

These are the kinds of measures that will be watched closely this week, to see whether the destructive cycle of declining confidence and illiquid debt markets has halted.

If it doesn't, the Fed will likely cut interest rates on or before Sept. 18, the date of its next scheduled policy meeting.

----

Serena Ng and Robin Sidel in New York, Iain McDonald in Sydney, Jason Singer in London, and Andrew Morse in Tokyo contributed to this article.

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