By Justin Baer
An urgent call reached Ronald O'Hanley, State Street Corp.'s chief executive, as he sat in his office in downtown Boston. It was 8 a.m. on Monday, March 16.
A senior deputy told him corporate treasurers and pension managers, panicked by the growing economic damage from the Covid-19 pandemic, were pulling billions of dollars from certain money-market funds. This was forcing the funds to try to sell some of the bonds they held.
But there were almost no buyers. Everybody was suddenly desperate for cash.
He and the deputy, asset-management executive Cyrus Taraporevala, had spoken the night before, wrestling with how investors would respond to an emergency interest-rate cut from the Federal Reserve.
Now, they had their answer. In his 34 years in finance, Mr. O'Hanley had weathered plenty of meltdowns, but never one like this.
"The market is fearing the worst," Mr. O'Hanley told him.
March 16 was the day a microscopic virus brought the financial system to the brink. Few realized how close it came to going over the edge entirely.
The Dow Jones Industrial Average plunged nearly 13% that day, the second-biggest one-day fall in history. Stock-market volatility spiked to a record high. I nvestors struggled to unload even safe bonds, like Treasurys. Companies and government officials were losing access to the lending markets on which they rely to make payroll and build schools.
Prime money-market funds that are owned by big institutional investors and buy a lot of short-term corporate debt -- normally safe and boring -- had outflows of $60 billion in the week ending that Wednesday, financial-data firm Refinitiv said, among the worst ever. Some $56 billion in client money fled bond funds.
Interest rates on short-term corporate debt surged, peaking on March 25 at 2.43 percentage points above the federal-funds rate -- the highest it has been since October 2008, according to the Federal Reserve Bank of St. Louis.
The financial system has endured numerous credit crunches and market crashes, and memories of the 1987 and 2008 crises set a high bar for market dysfunction. But longtime investors and those who make a living on Wall Street say mid-March of this year was far more severe in a short period. Moreover, the stresses to the financial system were broader than many had seen.
"The 2008 financial crisis was a car crash in slow motion," said Adam Lollos, head of short-term credit at Citigroup Inc. "This was like, 'Boom!' "
A barrage of government programs has since pulled the system back from collapse. This account of what happened on one of the worst days the financial markets have ever seen, from many of the executives, money managers and Wall Street veterans who lived it, shows why the rescue effort was so urgent.
The Federal Reserve set the stage for the downturn on Sunday, March 15. Most investors were expecting the central bank to announce its latest response to the crisis the following Wednesday. Instead, it announced at 5 p.m. that evening that it was slashing interest rates and planning to buy $700 billion in bonds to help unclog the markets.
Rather than take comfort in the Fed's actions, many companies, governments, bankers and investors viewed the decision as reason to prepare for the worst possible outcome from the coronavirus pandemic.
A downdraft in bonds was now a rout.
Mr. O'Hanley was in a good position to see the crisis unfold. His bank provides vital, if unheralded, administrative and bookkeeping services for most of the world's biggest investors, and runs its own trillion-dollar money manager.
Companies and pension managers have long relied on money-market funds that invest in short-term corporate and municipal-debt holdings considered safe and liquid enough to be classified as "cash equivalents." They function almost like checking accounts -- helping firms manage payroll, pay office leases and move cash around to finance their daily operations.
But that Monday, investors no longer believed certain money funds were cash-like at all. As they pulled their money out, managers struggled to sell bonds to meet redemptions.
In theory, there should have been some give in the system. U.S. regulators had rewritten the rules on money funds in the wake of the 2008 financial crisis, replacing their fixed, $1 price with a floating one that moved with the value of their holdings. The changes headed off the panic that could ensue when a fund's price "breaks the buck," as one prominent fund had in 2008.
But the rules couldn't stop a panicked assault like this one. Rumors circulated that some of State Street's rivals would be forced to prop up their funds. Within days, both Goldman Sachs Group Inc. and Bank of New York Mellon Corp. stepped in to buy assets from their money funds. Both firms declined to comment.
This was bad news for not only those funds and their investors, but also for the thousands of companies and communities dependent on short-term loan markets to pay their employees. "If junk bonds back up, people can rationalize that away," Mr. O'Hanley said. "There's very little ability to rationalize trouble in cash.
A debt-investing unit of Prudential Financial Inc., one of the largest insurance companies in the world, was also struggling with normally safe securities.
When traders at PGIM Fixed Income tried that Monday to sell a batch of short-term bonds issued by highly rated companies, they found few takers. And banks were reluctant to step in as intermediaries.
"The broker-dealer community was frozen," said Michael Collins, a senior fixed-income manager at PGIM. "It was as bad as at any point during the great financial crisis."
Across the country in southern California, the head of the debt-trading desk at investment firm Capital Group Cos., Vikram Rao, tried to make sense of the dysfunction.
Mr. Rao, who was working remotely that Monday, walked down the 20 steps to his home office at 4:30 a.m. to discover the debt markets were already in disarray. He started calling the senior Wall Street executives he knew at many of the big banks.
Executives told him that Sunday's emergency Fed rate cut had swung a swath of interest-rate swap contracts in banks' favor. Companies had locked in superlow interest rates on future debt sales over the past year. But when rates fell even further, the companies suddenly owed additional collateral.
On that Monday, banks had to account for all that new collateral as assets on their books.
So when Mr. Rao called senior executives for an explanation on why they wouldn't trade, they had the same refrain: There was no room to buy bonds and other assets and still remain in compliance with tougher guidelines imposed by regulators after the previous financial crisis. In other words, capital rules intended to make the financial system safer were, at least in this instance, draining liquidity from the markets.
One senior bank executive leveled with him: "We can't bid on anything that adds to the balance sheet right now."
At the same time, the surge in stock-market volatility, along with falling prices on mortgage bonds, had forced margin calls on many investment funds. The additional collateral they owed banks was also booked as assets, adding billions more.
The slump in mortgage bonds was so vast it crushed a group of investors that had borrowed from banks to juice their returns: real-estate investment funds.
The Fed's bond-buying program, unveiled that Sunday, had earmarked some $200 billion for mortgage-bond purchases. But by Monday bond managers discovered the Fed purchases, while well-intentioned, weren't nearly enough.
"On that first day, the Fed got completely run over by the market," said Dan Ivascyn, who manages one of the world's biggest bond funds and serves as investment chief at Pacific Investment Management Co. "That's where REITs and other leveraged-mortgage products started getting into serious trouble."
That Tuesday, UBS Group AG closed two exchange-traded notes tied to mortgage real-estate investment trusts. By Friday, a mortgage trust run by hedge-fund firm Angelo Gordon & Co. had warned its lenders it wouldn't be able to meet its obligations on future margin calls.
For decades investors have eagerly scooped up state and local government bonds month after month, week after week, every week. But that came to a standstill in mid-March.
Terrified investors ditched municipal debt at fire-sale prices, underwriters canceled billions of dollars worth of deals and new borrowing stopped. There was less bond issuance in the week of March 16 than at any point during the 2008 financial crisis, the 2001 terrorist attacks or the week of 1987's Black Monday, according to Refinitiv data, adjusted for inflation.
For those few days in March, investors lost faith in America's public infrastructure. As schools and universities shut down and airports and public transit systems emptied out, the market began to question what had been previously considered gold-plated bets on the core institutions that make up community life in the country.
The deep trouble in the market was clear early on the morning of March 16.
Cities and states often rely on short-term debt issued through bond dealers, who then resell the securities to investors. Billions of dollars of that paper was up for resale the following day. Rates, which had been around 1.28%, looked like they could reach 6%.
At the same time, long-term municipal-bond deals were being pulled. Over the course of the week Citigroup Inc., the second-biggest underwriter in the municipal market, wouldn't launch a single new bond.
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