Why did Paulson and Bernanke start running around with their hair on fire two weeks ago? This Wall Street Journal article on the consequences of Lehman’s collapse, “Lehman’s Demise Triggered Cash Crunch Around Globe,” sheds light on it:
Even as Morgan Stanley’s call was taking place, the Lehman fallout cropped up in a different corner of finance: so-called money-market funds, widely seen as a safe alternative to bank deposits. Many of the funds had bought IOUs, known as commercial paper, which Lehman issued to borrow money for short periods. Now, though, the paper was worth only 20 cents on the dollar.
At around 5 p.m. New York time, a well-known money-market fund manager called The Reserve said that its main fund, the Reserve Primary Fund, owned Lehman debt with a face value of $785 million. The result, said The Reserve, which had criticized its rivals for taking on too much risk in the commercial-paper market, was that its net asset value had fallen below $1 a share — the first time a money-market fund had “broken the buck” in 14 years.
The trouble in the commercial-paper market presented a particularly serious threat to the broader economy. Companies all over the world depend on commercial paper for short-term borrowings, which they use for everything from paying salaries to buying raw materials. But as jittery money-market funds pulled out, the market all but froze.
Today, the Fed acted directly to try to boost the commercial paper market.