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Financial Panic

The government’s takeover of Fannie and Freddie arguably ignited the global financial panic. The Treasury Department’s decision to wipe out shareholders of two of the largest financial institutions on the planet shocked markets, making it apparent that no institution was safe. Investors in all financial institutions questioned the value of their shares, bonds, and loans.

The weakest link in the financial system was investment house Lehman Brothers; it came under immediate pressure as shareholders dumped stock and short-sellers took advantage of the down-draft. Lehman had access to cash, thanks to the Fed, but one by one, Lehman’s business partners dropped away, seeing the firm as too risky to do business with. The company spiraled toward bankruptcy.

The Treasury and the Fed worked feverishly to find a buyer for Lehman but came up short for several reasons. One was Lehman’s extensive operations in London, which meant British banking officials needed to be involved. Treasury officials ultimately decided not to intervene, arguing that they couldn’t bail out every financial institution and that Lehman’s counterparties had had plenty of time to prepare after the Bear Stearns collapse 6 months earlier. The Fed went along, arguing that it could not by law loan Lehman any more without collateral.

This was a grievous mistake. The Fed and Treasury misjudged what a Lehman bankruptcy would mean. One of the nation’s oldest money-market funds, the Reserve Primary Fund, held a sizeable amount in Lehman paper. As that investment collapsed, the Reserve Fund “broke the buck”—the value of its assets fell below what it owed its investors—which in turn broke the confidence of small investors who thought of a money fund as one step removed from a mattress. Other money-market funds saw redemptions surge, forcing them to sell off short-term IOUs called commercial paper, which many large firms issued for ordinary working cash needs. The market seized up, terrifying investors: If firms couldn’t issue commercial paper, many couldn’t meet payrolls, finance inventories, or pay vendors. A huge amount of commerce would simply cease.

Other major financial institutions were teetering. The venerable investment house Merrill Lynch, fearing Lehman’s fate, hastily sold itself to Bank of America. Shakier banks suffered silent runs as scared depositors with more than the FDIC-insurance limit of $100,000 moved funds. Wachovia, a top-five commercial bank, was forced to sell itself to rival Wells Fargo, and Washington Mutual, the nation’s largest savings and loan, was seized by bank regulators and sold to JPMorgan Chase.

In the midst of this turmoil, insurance colossus American International Group told policymakers that it, too, was in serious financial trouble. The company had been aggressively writing insurance on mortgage-backed securities via the credit default swap market. As the value of those securities declined and the cost of the insurance it was providing rose, AIG debt was downgraded by the credit rating agencies. Other financial institutions that had bought credit insurance demanded more collateral, which AIG didn’t have. AIG was nearly broke and the financial system was shutting down.

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