A Total Market Melt Down Spurs Government Reaction

If you just returned from a week long vacation on an island, you would be wondering what all the commotion was about.

For the week taken as a whole, the market experienced just a modest rise. Stocks gained less than 1% — the S&P 500 up 0.3% and the Nasdaq 0.6%. But, that doesn't come close to telling the story...

This last week was one of Wall Street’s most remarkable and turbulent weeks in it's history. A week that overturned a financial order built over decades and changed the face of the financial landscape forever.

Lehman Brothers filed for bankruptcy. American International Group agreed to a bailout that ceded control to the Federal Government. Merrill Lynch agreed to be bought by Bank of America. With Morgan Stanley searching for a buyer, that would have left Goldman Sachs as the last big independent broker.

The week shook the foundations of the world financial system.

The London Interbank Offered Rate rose dramatically during the week, pointing to the reluctance of banks to make overnight loans to one another. At one point midweek, the yield on Treasury bills fell to nearly zero as investors raced to the safest of havens. The financial system seemed to be unraveling at the seams.

On Thursday night and Friday, the government took unprecedented steps to avert what some feared would be a complete melt down our financial markets. All of these problems had their root in large portfolios of defaulting mortgages. Those firms that owned those mortgage backed securities could not sell them, because they were being viewed as essentially worthless. These faltering firms did not have the capital necessary to avoid the losses.

Something had to be done to avert unmitigated disaster. Thursday, Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke met with congressional leaders. That night they began to craft a plan to buy those illiquid mortgage securities and then auction them off at some later date.

Details were not discussed, probably because no one has really worked them out. Friday's announcement by Mr. Paulson was short and he quickly exited the conference after fielding a minimum of questions. In lieu of details, the plan is being compared to the Resolution Trust Corp., that was formed after the failure of savings and loans associations in the late 1980s.

Money-market funds, a safe haven where institutions and small investors alike park cash, came under unprecedented pressure in their nearly 40-year history. The Treasury Department said Friday morning that it would activate a fund to protect money-market funds.

The Securities and Exchange Commission issued a temporary ban on selling financial stocks short. The ban runs through Oct. 2, but the SEC could, if necessary, extend it another 30 days. The SEC also eased rules to make it easier for companies to buy back their own shares.

The Federal Reserve expanded its emergency lending to allow commercial banks to finance purchases of asset-backed paper from money market funds. It also said it would buy short-term debt from Fannie Mae, Freddie Mac and the Federal Home Loan Banks.

On Tuesday, the Reserve Primary Fund, the original money fund, was forced to write off $785 million in Lehman notes, 1.2% of its portfolio. As a result, its net asset value fell to 97 cents from $1, meaning investors lost 3 cents of every dollar. It froze redemptions after investors pulled out nearly two-thirds of their money during the previous two days.

That was the first time since Orange County, Calif.’s bankruptcy in 1994 that a money-market fund had “broken a buck.” The next day, Reserve announced that two other funds had broken a buck, including a fund exclusively for offshore investors that will return only 91 cents of every dollar invested.

It got worse. Wachovia’s Evergreen Investments, Bank of America’s Columbia funds, Ameriprise Financial, Legg Mason and Frank Russell Funds said they were either shoring up staggering money funds or stood ready to do so to prevent them from breaking a buck.

On Wednesday alone, investors yanked $89.2 billion, or 2.6% of total assets, out of money funds, which the day before held $3.44 trillion. The next day, Putnam announced that it was liquidating a money fund that was under pressure from redemptions.

So, there was a lot on the minds of investors and traders during Friday's session. Add to the fact that this was a quadruple witching trading day, the short covering, and you got the sense that anything could happen.

Whew! What a week, and less than a 1% change to show for it all...

Christopher Smith
TheOptionClub.com