The Federal Reserve released the minutes from 2008 during the height of the Subprime Liquidity Crisis Friday, which showed that the Board had little appreciation for the damage that the bankruptcy of Lehman Brothers was about to inflict upon markets and upon the world economy. (They erroneously thought AIG was larger risk to money funds than Lehman.) The Fed's "Meeting of the Federal Open Market Committee on September 16, 2008" quotes Bill Dudley, "Now, the Lehman filing has also intensified the pressure on Morgan Stanley and Goldman Sachs in a number of respects. The Lehman failure means that investors now view the debt of Morgan Stanley and Goldman Sachs as having much more risk than it did on Sunday. This means that these firms need bigger liquidity buffers than they had before.... Morgan Stanley experienced a modest, but not insignificant, pulling back of their counterparties and ate into their liquidity buffer by a measurable degree." (Note: Lehman Brothers had declared bankruptcy the night before, Sunday night, and Reserve Primary Fund would "break the buck" the following day, triggering a run on Prime Institutional money funds and a freeze in major portions of the money markets. See our "News" archives from Sept. 2008 for more.)

They continue, "The Lehman problems also were evident in some other areas. This is very incomplete, but the ones that came to my attention were money market funds -- especially, the Reserve Fund that had large withdrawals, and they encountered a significant liquidity problem. I am actually not sure how that was resolved, but I think that State Street was in the situation of having to cover a very large shortfall of the Reserve Fund last night. The risk here, of course, is that, if AIG were to fail, money funds have even a broader exposure to them than to Lehman [sic], and so breaking the buck on the money market funds is a real risk. The capital resources of the entities that are associated with the money market funds often are quite modest, so their ability to top up the money funds and keep them whole is quite limited. Thus the money market funds are definitely one important issue in how this contagion could be broader."

The Fed's Dudley continues, "Of course, we also have the issue of AIG. The AIG problem is at least starting as a liquidity crisis. The problem with AIG is that the parent company doesn't have a lot of liquidity resources and doesn't have easy ability to funnel liquidity up from their subsidiaries because most of the subsidiaries are regulated entities. So AIG is running into two problems: One, they are unable to roll their commercial paper and, two, as their ratings are downgraded -- they were downgraded by Moody's yesterday, I think from AA minus to A minus, but don't quote me on that -- they have to post a lot more collateral against their derivatives exposures and also with respect to their GIC (guaranteed investment contract) business. So AIG is in a situation in which the parent is basically going to run out of money -- today, tomorrow, Thursday, or very, very soon. Now we say it's a liquidity thing, but a lot of times when people look closer at the books they find out that the liquidity crisis may also be a solvency issue. I think it is still a little unclear whether AIG's problems are confined just to liquidity. It also may be an issue of how much this company is really worth."

He tells the meeting, "Finally, let me talk a bit about the facilities that we introduced over the weekend. Basically, we did two things. We broadened the Primary Dealer Credit Facility (PDCF) significantly in terms of collateral eligibility. Whereas, before, the PDCF took investment-grade securities only, we broadened it to include basically everything that is in the tri-party repo system. We felt that, by backstopping the tri-party repo system completely, we would reassure tri-party investors that they didn't face rollover risk, and so we would keep tri-party investors investing with the banks. That seems to be mostly what happened, at least yesterday. We did get quite a bit of PDCF borrowing yesterday evening, but it was predominantly Lehman. It was about $28 billion of Lehman borrowing. I think the total borrowing was something on the order of $42 billion."

Dudley adds, "That is telling you that most of the borrowing we had was associated with Lehman's not being able to roll over their tri-party repo positions with their investors. We don't really know the reasons for the other borrowing, but it probably was mostly to test the facility as opposed to actual need. So broadening the PDCF collateral eligibility does seem to be working, so far at least, in keeping tri-party investors in the game and continuing to provide funds to the other primary dealers."

Later, the Boston Fed's Eric Rosengren comments, "Just an amplification on the State Street situation. My understanding is that no money actually went out. There was $20 billion in withdrawals that came in late in the day. They had a $7.5 billion credit line. State Street had enough collateral to do $7.5 billion. They were unwilling to do $20 billion. They asked us what our position was, and we told them that they needed to make their own business decision in this case. I haven't heard what has happened this morning. I assume that they are scrambling for funds. But I would emphasize that a real concern is that there will be a run this week on money market funds because they may have to freeze the funds. It is possible that they will break the buck, and this will be at organizations that don't have sufficient capital to make people whole. So I think that is a real concern."

The Richmond Fed's Jeffrey Lacker adds, "I know there was a lot of concern going in yesterday about the tri-party repo market, and I envisioned two scenarios and anything in between them. One is tri-party lenders pulling away from particular names and moving their funds to other names. Another, at the other extreme, would be tri-party repo lenders pulling away from the market as a whole. If you look at the tri-party repo market from the point of view of the borrowers, that is a frightening scenario. Then the lenders are going to do something with that money. I have been curious about what they would do. My understanding is that cash balances, in essentially deposit accounts, piled up at State Street and BONY yesterday and that they were able to do tri-party repos with some institutions that had been pulled away from. Is that a valid observation? What are the prospects for that providing some kind of resilience for the tri-party market?"

Dudley answers, "Well, I guess the first thing I would say is that you are absolutely right. If investors pull away, they have to take their money somewhere. It doesn't disappear. I think that the Primary Dealer Credit Facility has been shown to be pretty significant in providing support to this market. If you look at what happened to Lehman, for example, even though Lehman was under extreme pressure on Friday, the tri-party repo investors stayed with Lehman on Friday night, which actually surprised me. I think the reason that they stayed is that they knew they didn't really have a lot of rollover risk. As long as the broker-dealer didn't file for bankruptcy over the weekend -- and that was the risk they really were taking -- the Federal Reserve and the PDCF would be there as the tri-party repo investor of last resort."

He says, "Lehman's experience suggests to me that, if we can contain the broad parameters of this crisis so that it doesn't spread much further, then we can keep the tri-party repo investors from bolting because they don't really have a huge amount of risk as long as we are there behind them to take them out when their overnight obligation comes due the next day."

Lacker asks, "So, if I can just follow up, my understanding is that tri-party repos are exempt from the automatic stay, so it is not filing per se that is the risk. It's the risk that they don't have the cash, right?" Dudley answers, "Well, I'm not sure about that. I thought that there was an issue about broker-dealer filing. I know that the clearing banks are certainly quite nervous about that eventuality, but I'm not a lawyer." Finally, a Mr. Parkinson comments, "The repos are exempt from the automatic stay provisions of the bankruptcy code. But if Lehman had gone into SIPA liquidation, they could have been subject to a SIPA stay."

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