How "ice-nine" caused the credit crunch

Welcome to the Twilight Zone: Bloomberg News invokes Kurt Vonnegut to explain the financial crisis


Andrew Leonard
September 10, 2009 2:18PM (UTC)

The best part of the Bloomberg News article explaining how bad money market fund investments in "commercial paper" precipitated last fall's credit crunch: The use of "ice-nine" -- a fictitious material in Kurt Vonnegut's "Cat's Cradle" that freezes the entire world's oceans -- as a metaphor for how investor fear of commercial paper brought the world's credit markets to a standstill.

Worst part of the same Bloomberg News article: the title "Sleep-At-Night-Money Lost in Lehman Lesson Missing $63 Billion." I've read the article twice and I still can't make head or tail of that headline. Are computers writing Bloomberg display copy now?

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But, despite the title, reporters Bob Ivry, Mark Pittman and Christine Harper manage to put together an interesting tale that fills in some hitherto obscure gaps in our knowledge of what happened during the fateful week following the bankruptcy of Lehman Brothers.

Never mind the nefarious credit-default swaps or bewilderingly complex mortgage-backed securities -- the real villains in the credit crunch, argues Bloomberg, were money market funds that were snapping up as much commercial paper as they could, after the the financial crisis was already well under way, following the implosion of Bear Stearns.

Commercial paper refers to short-term debt that corporations use to fund their ongoing operations. They are unsecured, which means that if the company that issues the debt can't make good on its obligations when the debt matures, the lender has no recourse.

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Bloomberg shines a harsh light on Bruce R. Bent, the creator of the first money market fund ever, the Reserve Primary Fund.

For years, Bent had shunned commercial paper as too risky and scolded managers of other funds for sacrificing safety to earn higher yields... Then, in August 2007 the commercial-paper and other credit markets froze as a result of deteriorating mortgage values. Banks such as Citigroup had funded the home loans in their structured investment vehicles, or SIVs, with commercial paper, and now the off-balance-sheet pools were collapsing because investors stopped purchasing their short-term notes. When SIV managers put their debt up for sale for as little as half the face value, Bent went on a buying spree, according to the Investment Company Institute, a fund-industry trade group in Washington.... From July 2007 to July 2008, the commercial-paper portion of Reserve Primary's holdings jumped to almost 60 percent from 1 percent, according to the trade association.

When Lehman Brothers went bankrupt, Primary Reserve Fund was left with nearly $785 million worth of Lehman commercial paper that was effectively worth nothing. The chaos and confusion in the financial markets, in turn, led investors in the fund to start clamoring to get their money back. But Primary Reserve did not have enough cash in hand to return their money -- the majority of its holdings were made up of commercial paper that was either worthless or impossible to put a price on.

By 1 p.m. on Monday, Sept. 15, in New York, less than 13 hours after the 12:37 a.m. bankruptcy announcement, client demands for immediate cash-outs totaled $18 billion, more than a quarter of the fund's assets. Even more alarming, Reserve Primary's bank, Boston-based State Street Corp., had quit honoring withdrawal requests.

Several months later, while appearing on CSPAN, Rep. Paul Kanjorski, D-Pa., chairman of the House Capital Markets Subcommittee, recalled that later that week Hank Paulson and Ben Bernanke had warned congressional leaders that a run on the money markets threatened "the end of our economic system and our political system as we know it." The figures Kanjorski cited never quite added up, but there seems little question that the money market funds were indeed imploding.

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But the fact that at least one of them, Primary Reserve Fund, owed its misfortune to its decision to bet heavily on commercial paper after the credit crunch had already begun is new to me. And just more example of why depending on markets for prudent risk management and self-correction seems unwise.


Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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