How ‘The Roof Caved In’ on Wall Street

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AIG had a trillion dollars in assets. It did business in every part of the world and it had written credit default swaps on $2.7 trillion worth of debt instruments. While there was debate about whether a bankruptcy filing by Lehman Brothers would devastate the financial system, there were no such arguments about the effect of a bankruptcy for AIG. Among the people whose opinion I have come to trust over my career, the conclusion was unanimous: AIG’s failure would cause a systemic breakdown of the financial system given its deep and broad ties into every part of that system. As that Monday evening’s telecast came to a close, it looked like the Fed was going to test that conclusion.

Strange things were happening in the credit markets. Confidence, already sorely tested the past 13 months, was all but gone. Financial institutions were severely cutting back on lending to one another in a disturbing pattern that would crest three days later. But still the Fed was not ready to lend AIG money. I had reported on Monday that the investment bank Morgan Stanley and law firm of Wachtel, Lipton had been hired by the Fed to advise it on AIG. It seemed a promising sign for those who were hoping the company would be saved. But as Tuesday began there was no sign that a loan would be forthcoming. That Tuesday morning I reported definitively, based on my conversations with numerous sources who knew, that if AIG did not receive money from the Federal Reserve it would file for bankruptcy the next day.

The Fed blinked. Reluctant as Treasury Secretary Henry Paulson may have been to take the unprecedented step of lending billions of taxpayer dollars to a publicly traded insurance company, the risk of not doing so was too large to take. The Fed’s initial recalcitrance had proved costly. What was $20 billion on Sunday and $40 billion on Monday had amazingly become $85 billion by Tuesday night. AIG ’s business had deteriorated that quickly. The downgrade of its credit rating on Monday night had forced it to post billions in additional collateral. I reported the news that night in what had become our customary breaking news programming. AIG would receive an $85 billion bridge loan from the federal government with a term of two years and an interest rate of LIBOR (London Inter-Bank Offer Rate) plus 8.5 percent. In return for that loan, the federal government would take control of the giant insurer by obtaining 79.9 percent of the company’s public shares. The American taxpayer had just bought itself the biggest, most troubled insurance company in the world.

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When the credit crisis began in the late summer of 2007, I turned to a group of people I had been speaking with for 20 years to get insight about its significance. I started as a banking reporter in the mid-1980s, and one of the few benefits of growing older is that your sources do, too. The midlevel executives I had spoken with in the 1980s were now running many of our nation’s banks. Even in the earliest days of the crisis, when financial institutions were only beginning to show trepidation about extending credit and the stock market was about to hit new all-time highs, my sources were certain that we were in for deep trouble. The investors in the stock market seemed to have no idea what was going on in the credit markets — no idea of how hard it had become to get a loan, even if it was of extremely short duration, and no idea, it seemed to me, of what that fact would mean for our financial markets or our economy.

On Wednesday, after another late night of broadcasting, many people believed that while there was more bad news to come, the worst of the financial tsunami had passed. But those people weren’t paying attention to the credit markets. In those markets, panic was setting in.

The credit markets are similar to a sewer system. When they are working well, no one thinks about them. In the same way that we don’t question where that clean water that comes out of our tap is actually coming from, most professionals on Wall Street or Main Street don’t give much thought to the free flow of credit. It is something we accept as a constant. But when that credit gets backed up, it is reminiscent of a malfunctioning sewage system. People start to notice. And to take the simile one step farther, if a broken sewage system does not get quickly repaired, a host of malicious diseases is not far behind.

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A year after my sources had first warned of the deep trouble toward which we were heading, we had found it. Banks that had not been making loans to corporations or consumers were now leery of making loans to each other. The commercial paper market, which had been slowly drying up for a year, was now closed to almost every borrower. And most terrifying of all, fear was starting to spread throughout the system. Every debt security, other than the debt issued by our government, was suspect. People were pulling money out of every conceivable form of debt and pulling their money out of their bank accounts for fear their bank would soon fail.

Panic is not typically rational. But the threat of panic made rational people prepare for the worst, which meant doing the very same things those who were panicking were doing. Money was coming out of everything, including heretofore-safe money market accounts and heading into Treasury bills and bonds. In a reflection of the panic, people were buying three-month Treasury bills that offered no interest rate. They were giving the U.S. government their money and only asking that it be returned to them three months later.

The conversations I began having with my longtime friends and sources (often one and the same) took on a surreal quality. Can you really put money in a mattress? Can I bury gold bullion in my backyard?

Should I buy a safe and a gun? What happens when people lose all faith in the currency and it simply becomes a piece of paper? What happens when everyone loses confidence in the creditworthiness of everyone else?

And then, on Thursday morning, September 18, we were face to face with it. Over the past few days, a handful of money market funds had seen vast redemptions that were forcing them to liquidate their holdings. The panic had started when one such fund lost value after it suffered losses from its holdings of debt of the now-bankrupt Lehman Brothers. Some funds were forced to stop their own investors from withdrawing their money immediately, which showed more panic. The money market funds, typically large buyers of commercial paper, had completely withdrawn from that market. In the same way that AIG had been shut out of the commercial paper market six days earlier, now even corporations without any connection to the financial services business were finding it impossible to borrow. And even banks that had always been happy to lend to each other were no longer willing to do so.

Thirteen months after our crisis in credit began, the United States and the rest of the world were about to watch the financial system implode. Countless corporations would be forced to file bankruptcy.

Commercial banks and investment banks, watching their depositors and trading partners exit en masse, would quickly become insolvent.

The word credit is derived from the Latin credere, which means “to believe.” When the belief that you will be paid back disappears, there is no credit. Belief is the lifeblood of a healthy financial system and its disappearance brought the very real possibility that the United States and much of the Western world would be thrown into a financial cataclysm the likes of which we had never seen.

How did we come to this point? How did we lose Bear Stearns in March and Lehman Brothers six months later? How could Merrill Lynch have been forced to sell itself? How did the American taxpayer end up owning AIG? And after all that, how was it that our system itself was still teetering on the edge of collapse? That story begins seven years earlier, in the rubble of the World Trade Center.

Financial advice

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How ‘The Roof Caved In’ on Wall Street