Dow Drops 500 Points as Wall Street Reels

Lehman Brothers' bankruptcy filing, BofA's deal to acquire Merrill, and AIG's call for funding sparked a global sell-off Monday. What will Tuesday bring?

By BusinessWeek, Associated Press, and Action Economics staff

With selling accelerating in the final hour of trading, major U.S. stock indexes suffered their worst percentage losses in nearly six years Monday, with the blue chip Dow Jones industrial average diving over 500 points.

On Monday, the Dow Jones industrial average tumbled 504.48 points, or 4.42%, to finish the session at 10,917.51, ending below the psychologically significant 11,000 level. The broader S&P 500 index plunged 57.98 points, or 4.63%, to 1.193.72, breaking below its July lows. The tech-heavy Nasdaq composite index sank 81.36 points, or 3.60%, to 2,179.91.

Market breadth was overwhelmingly negative. On the New York Stock Exchange, 30 stocks declined in price for every one that advanced. The ratio on the Nasdaq was 24-3 negative. Trading was active, reports S&P MarketScope.

European markets stumbled, though they finished above session lows. London stocks were off 3.87%, Frankfurt was off 2.74% and Paris was down 3.78%. Asian markets were closed for holidays.

The rout capped a global sell-off after a cataclysmic chain of events for major Wall Street firms over the weekend, raising concerns about the health of financial markets. Investment bank Lehman Brothers (LEH) filed for bankruptcy protection, while rival Merrill Lynch (MER) agreed to be taken over by Bank of America (BAC) and the Federal Reserve threw a lifeline to the battered financial industry. Shares of troubled insurer American International Group (AIG) plummeted as the firm asked for financial help from the Fed.

According to a Wall Street Journal report late Monday afternoon, the government obliged -- sort of -- by asking Goldman Sachs (GS) and J.P. Morgan Chase (JPM) to lead a $70 billion-$75 billion lending facility for AIG.

U.S. Treasuries surged Monday as investors sought the relative safe haven of government debt amid speculation that global central banks might do a coordinated rate cut. The Federal Reserve's next scheduled policy meeting is on Tuesday.

Gold futures were higher, as was the dollar index. Oil futures were off as Hurricane Ike caused limited damage to energy installations in the Gulf of Mexico.

At the end of Monday's session, investors were left with more questions than answers.

"Can Lehman's positions be unwound in an orderly fashion? Will the resulting downward pressure on asset prices force others to recognize further losses of their own? What will be the impact of a possible round of asset liquidation by AIG and possibly others? Are there other firms in dire straights that have not yet hit the radar screen? And how will investors react in the face of such unknowns with headlines screaming of crisis?" asked David Joy, chief market strategist for RiverSource Investments, in a note Monday.

The financial sector, save for Merrill Lynch, took a terrible pounding after the weekend's drama. AIG plummeted 61%, Bank of America was down 21%, Washington Mutual (WM) fell 27% and Wachovia (WB) skidded 25%.

Other financial firms posted smaller, though still painful declines: Citigroup (C) was down 15%, Morgan Stanley (MS) fell 14%, Goldman Sachs (GS) shed 12%, and JPMorgan Chase (JPM) lost 10%.

Merrill shares, after being sharply higher much of the day on the merger news, fell back to finish nearly unchanged as the BofA stock to be used in the acquisition of the firm plummeted.

Lehman shares sank to 21 cents after its bankruptcy filing.

Market volatility was elevated Monday. The VIX (S&P 500 market volatility index), a widely followed fear gauge for the stock market, was up 20% to 30.81.

"A VIX well north of 30, possibly above the 35 level we think would do a lot toward showing some real fear and panic in the options market. We believe that until we get some real panic in the majority of the sentiment readings, a real bottom to this bear market is unlikely," wrote S&P chief technical strategist Mark Arbeter in a note Monday.

"The news today was very bad, and the lack of any recovery in stocks or downturn in Treasuries indicates the financial markets don't believe the worst is over," wrote S&P MarketScope analysts.

Meanwhile, officials were scrambling to calm nervous investors. President Bush sought to assure Americans about the markets in a statement Monday.

Treasury Secretary Henry Paulson said in remarks Monday that the U.S. is working through a "difficult time," adding that Americans can have confidence in the markets. He reminded that the housing market has been the root of the economic challenges, and said the moves taken by the Fed, SEC, and Treasury have helped minimize the disruptions. He was impressed at how the financial institutions came together. Regarding commercial banks, he said the banking system is a "safe and sound one" and Americans can be "very confident" in U.S. banks.

There was speculation the Federal Reserve, European Central Bank, and Bank of England would make coordinated rate cuts amongst the major central banks and take new liquidity measures.

"A rate cut at tomorrow's [FOMC] meeting has increased in likelihood, but would probably be done only in combination with the ECB," says S&P chief economist David Wyss.

"We still don't believe a rate cut is the appropriate solution to the current financial crisis, and indeed we suspect many at the Fed are of similar opinion. And if the markets stabilize somewhat by tomorrow, and stocks recover, policymakers are likely to leave rates on hold and address the issue with its policy statement," wrote Action Economics analysts Monday.

European Central Bank president Jean-Claude Trichet said the bank must be "extraordinarily alert" on the financial-market environment. He added that that "it is an ongoing market correction" with episodes of a high level of volatility. The ECB earlier Monday alloted 30 billion euros in extra funds to ease market liquidity as interbank rates jumped higher.

Meanwhile, China cut its benchmark interest rates and required reserves.

The Fed also did its part to keep the markets running more or less smoothly, announcing measures to add liquidity, including allowing all investment grade debt securities to be used for the TSLF schedule two auctions, which will now be held every week instead of every two weeks.

Still, credit market conditions were dicey. The Federal reserve moved massive liquidity into the financial system with an injection of $70 billion, with the Fed funds rate trading at 6%, three times the current funds rate target. "It ... looks like the $70 billion in repos this morning is loosening up the funds rate, which as dipped back to 4%," according to Action Economics.

More liquidity measures were also announced by a consortium of banks including Bank of America, Barclays, Citibank (C), Credit Suisse (CS), Deutsche Bank (DB), Goldman Sachs (GS), JP Morgan Chase (JPM), Merrill Lynch, Morgan Stanley (MS), and UBS (UBS) to maintain trading relationships and credit terms, to establish a $70 billion collateralized borrowing facility and to "facilitate an orderly resolution of OTC derivatives exposures between Lehman Brothers and its counterparties."

PIMCO bond fund manager Bill Gross doesn't expect the Fed to cut Tuesday, but given the extent of the credit crunch he hopes that the language in the FOMC statement could pave the way for more accommodative policy ahead.

Investors were faced with a dizzying array of bad news Monday, with catastrophe seeming to lurk in every corner of Wall Street.

The Wall Street Journal reported that AIG, succumbing to relentless investor pressure that drove its shares down 31% on Friday alone, is pulling together a survival plan that includes selling off some of its most valuable assets, raising more capital and going to the Federal Reserve for help, people familiar with the situation said. The measures are aimed at staving off a downgrade by major credit-rating firms. The insurer, which has already raised $20 billion in fresh capital so far this year, was seeking to raise an additional $40 billion to avoid a downgrade.

New York Share Gov. David Patterson reportedly said Monday that AIG has been given permission to access $20 billion of its of capital to free up liquidity.

Like other insurers, AIG has been hit hard by deterioration in the credit markets amid concerns that complex, structured investments it insures will increasingly default. For the three quarters ended in June, AIG lost about $25 billion in the value of credit default swaps -- or default protection for bondholders -- and about $15 billion on other investments.

According to a CNBC report, the Fed hired Morgan Stanley to structure a bridge loan for AIG perhaps using the Fed window to buy them time until Wednesday to get a deal done.

There were fevered, weekend-long attempts to reach a buyer for troubled investment firm Lehman Brothers, which ultimately failed, as the 158-year-old investment bank said it would seek bankruptcy protection. The company's shares have plunged 95% in the past year over worries that it does not have enough money to cover losses from its massive real estate holdings.

Expectations that Lehman would survive dimmed Sunday afternoon after Barclays (BCS) withdrew its bid to buy the investment bank. Barclays and Bank of America were considered front-runners to buy Lehman, which was foundering under the weight of $60 billion in soured real estate holdings.

There was a special derivatives trading session Sunday afternoon so that players could cut risk.

Bank of America said it has agreed to acquire Merrill Lynch in a $50 billion all-stock transaction, forming a global financial behemoth. Under terms of the transaction, Bank of America would exchange 0.8595 shares of Bank of America common stock for each Merrill Lynch common share. The price is 1.8 times Merrill's stated tangible book value.

Bank of America said it expects to achieve $7 billion in pretax expense savings, fully realized by 2012. The acquisition is expected to be add to BofA's earnings by 2010.

An official of a major financial firm contacted by the Associated Press Sunday said the Treasury Dept. and the Fed had pushed Bank of America to buy Merrill Lynch. On Friday, Merrill's shares fell as investors fretted it might be the next investment bank to come under pressure from its portfolio of risky mortgage-backed securities. Merrill shares closed at 17.05 on Friday, after falling sharply in the wake of Lehman's looming demise.

Meanwhile, Action Economics reported Monday morning that the markets were abuzz with rumors that Morgan Stanley (MS) and Goldman Sachs (GS) in merger talks.

In economic news Monday, U.S. industrial production fell 1.1% in August after rising 0.1% in July (revised down from 0.2%). June production was also revised down. That knocked capacity utilization down to 78.7% from 79.7% in July (79.9% previously).

The U.S. Empire State manufacturing index fell over 10 points to -7.4 in September after improving 7.7 points to 2.8 in August. The employment index was steady at -4.6 versus -4.5 previously. The new orders index improved to 4.4 after falling to -2.2 in August. Prices paid dropped to 44.8 from 65.2, while prices received were 24.1 from 32.6. The six-month general business conditions index rose to 43.1 after more than doubling to 34.6 in August.

Markets were awaiting the release of the August consumer price index on Tuesday for a further read on inflation.

Energy futures plunged Monday, partially because Hurricane Ike's damage to Houston-area refineries and Gulf of Mexico oil platforms was minimal. But the market was also hammered by the news out of Wall Street, with many believing the financial turmoil could lead to a steeper than expected recession that would reduce the demand for oil and other commodities. October West Texas Intermediate crude oil futures were off $6.31 to $94.87 in late trading Monday.

Gold futures rose in a flight to safety. As of Monday afternoon, gold was up $22.40 at $786.90 an ounce, according to S&P MarketScope.

Treasuries were catapulted higher by a flight to safety in the wake of Wall Street's woes Monday. The 10-year note soared 67/32 to 104-15/32 for a yield of 3.46%. The 30-year bond skyrocketed 100/32 to 106-15/32 for a yield of 4.12%.

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