Wall Street crisis could have far-reaching, long-lasting impact

WASHINGTON — Wall Street shook to its foundations Monday after a series of historic events that included the bankruptcy of a major investment bank, the hastily arranged sale of another and the near collapse of one of the most iconic of blue-chip companies.

The Dow Jones Industrial Average closed down 504 points, or 4.4 percent, to 10,917.51 — its lowest close in two years and its steepest one-day decline in seven years. The S&P 500 fell by 4.7 percent and the technology heavy Nasdaq was down 3.6 percent.

The colossal market drop came on an unprecedented day that featured Wall Street mainstay Lehman Brothers filing for Chapter 11 bankruptcy protection and the sudden, breathtaking sale of investment bank Merrill Lynch to Bank of America for $50 billion.

If those events weren't enough, one of the nation's most important insurance and financial services companies, American International Group, teetered on the verge of collapse as investors bailed out and its shares lost more than 60 percent of their value in a single day. AIG, one of the 30 blue-chip component stocks of the Dow Jones Industrial Average, is far larger than the investment banks that have failed or have been sold.

At the center of the storm is a widening credit crunch that's causing lending of virtually any kind to seize up. Without lending, the economy faces peril.

"There's nothing like this in the postwar period," said Lyle Gramley, a veteran markets watcher who was a Federal Reserve governor during a turbulent period, from 1980 to 1985. "We aren't going into the Great Depression, no question about that. But we could get into a recession that accumulates if things don't get better in financial markets. I think we have to worry a lot that this may be the turning point that puts this economy into a very significant recession."

Wall Street fretted that AIG could be the next shoe to drop.

Late Monday, the Treasury Department and Federal Reserve rejected a request from AIG for an emergency loan and instead were pushing Goldman Sachs and J.P. Morgan Chase to create a private-sector emergency lending facility valued at least $70 billion to help AIG stay afloat while it tries to shed valuable assets to raise capital and remain solvent.

AIG's problems underscore why Wall Street is in a state of near panic. AIG isn't insolvent; it's already raised $20 billion this year to shore up its balance sheets.

But its falling stock is forcing it to sell assets such as its aircraft-leasing business and to plead for investment from private equity companies. It needs to raise about $40 billion in new capital but it can't borrow because of the credit crunch.

Monday night, the Wall Street Journal reported that Standard & Poor's had cut AIG's credit rating by three notches. The downgrade means that AIG will have to raise billions more capital or risk being in default.

"It's a perverse situation," Bill Gross, the chief investment officer of Pacific Investment Management Co., the world's largest bond fund, said on CNBC.

If AIG fails, it poses unique problems for financial markets because not only is it a conventional insurance company but it's also a big player in a complex parallel market called credit default swaps. That's where Wall Street companies take out a form of market insurance against the risks of bond default. This unregulated market was estimated in June 2007 to have a notional value of $42 trillion.

"The market is opaque, and it is opaque by design," said Howard Simons, the president of the economic research firm Rosewood Trading in Glenview, Ill., noting that there's no exchange or clearinghouse for unwinding these swaps if a big player goes bust. "It's going to come back and bite everybody, because now you are in an information vacuum."

Wall Street has suffered this kind of financial turbulence only a few times before, most notably during the Depression. Fed Chairman Ben Bernanke is one of the world's leading scholars on the Depression, and he's putting that knowledge to use as he tries to avoid a complete collapse of the global financial sector. On Sunday, he broadened the collateral the Fed is willing to take as it makes emergency lending to investment and commercial banks to keep them solvent.

President Bush tried to calm the waters Monday, using a White House visit by the president of Ghana to tell the nation that his administration is working to contain Wall Street's problems.

"As policymakers, we're focused on the health of the financial system as a whole. In the short run, adjustments in the financial markets can be painful, both for the people concerned about their investments and for the employees of the affected firms," Bush said. "In the long run, I'm confident that our capital markets are flexible and resilient, and can deal with these adjustments."

Wall Street's woes seem sure to make it harder to get a mortgage or car loan in the near future. But one silver lining for consumers is that oil prices fell by $5.47 a barrel Monday to $95.71.

Gasoline prices are likely to fall sharply in the weeks ahead, and inflation, which eats away at consumers' spending power, is also likely to ease as energy prices fall.

Problems at Lehman Brothers, a 158-year-old investment bank, began in March shortly after the Fed and Treasury Department brokered a weekend sale of rival Bear Stearns to J.P. Morgan Chase. Speculation immediately turned to Lehman, which like Bear Stearns was heavily weighed down by bad investments in mortgage bonds that had turned toxic.

On Friday, the government was helping Lehman shop for partners, but Treasury shot down reports that taxpayers' money would be used as it was for Bear Stearns, whose sudden collapse made regulators fear a global meltdown.

"The situation in March and the situation and the facts around Bear Stearns were very, very different to the situation we are looking at here in September," Treasury Secretary Henry Paulson told a White House news conference Monday afternoon. "And I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers."

What about AIG? After all, the Bear Stearns deal involved the Fed lending to investment banks it didn't regulate. And if regulators step in to help a giant such as AIG, what about automakers, airlines, builders and other industrial titans suffering through the financial crisis? Paulson was noncommittal, refusing to rule out future rescues but downplaying the need for them.

When does the crisis end? Paulson said it started with the housing market and would end when housing's problems ended.

"Until we stem the housing correction, until the biggest part of that is behind us and we have more stability in housing prices, we're going to continue to have turmoil in the financial markets," he said.

Kenneth Lewis, the chief executive officer of Bank of America and essentially the new king of Wall Street with his purchase this year of Merrill Lynch and mortgage-lending giant Countrywide Financial, wasn't optimistic about an early end.

"I don't see the clouds parting as I would like them to in 2009," he told a news conference, adding, "I think that's probably a 2010 situation."

As for his own company, based in Charlotte, N.C., Lewis said Bank of America took a risk in buying Merrill Lynch — itself a potential buyer of Lehman Brothers — because it saw potential reward.

"We thought this was the strategic opportunity of a lifetime," Lewis said.

The financial sector accounts for about 8 percent of the economy. That usually would mean limited spillover. But when measured more broadly as banking, finance, insurance and real estate, the sector is more than 20 percent of the economy, which explains the reverberating shockwaves.


More on the Federal Reserve's steps to boost markets:

Paulson's news conference:


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