Debt Fears Weigh on Stocks

Updated from 5:18 p.m. EDT

Stocks gyrated lower Monday as last week's government report on employment figures confirmed Wall Street's recession fears, raising more concerns about a full-scale panic gripping the debt-laden financial markets.

Rumors swirled throughout the trading day about possible failures in store for investment banks, and financial stocks swooned. Meanwhile, some investors called for an explicit backing of the government-sponsored mortgage buyers Fannie Mae(FNM Quote) and Freddie Mac(FRE Quote) by the federal government.

For its part, the Federal Reserve acted aggressively to pump liquidity out to shell-shocked banks, as speculation grew that larger rate cuts are in store from the central bank at its Federal Open Markets Committee meeting next week.

On Monday, the Fed offered $50 billion in 28-day credit through its term auction facility. Following the disappointing February employment report last week, the Fed on Friday announced it would increase the amount of credit being auctioned through the term auction facility in March from $60 billion to $100 billion.

Goldman Sachs said in a note to clients Monday that another emergency intermeeting rate cut from the Fed could not be ruled out, but it reiterated its view that the Fed would drop the benchmark federal funds target rate to 2% by late April in two 50 basis-point steps at the next two meetings.

On Wall Street, fed funds futures were recently pricing in a three-quarter point rate cut at the next meeting, with only a 4% chance of a half-point rate cut.

"The Fed is not in a position right now to disappoint the markets," says T.J. Marta, fixed income strategist with RBC Capital Market. "The entire financial system is in jeopardy at this point, but we're not seeing a market meltdown at this point. We're not seeing hysterical, uncontrolled price action."

The Dow Jones Industrial Average closed down 1.3% Monday, while the S&P 500 shed 1.6% and the Nasdaq Composite was off 2%. Shares of Fannie were down 13%, while shares of Freddie were down 11.5%.

Other financial stocks also suffered, with Bear Stearns (BSC Quote) losing 10.8%, Citigroup (C Quote) down 5.8% and Merrill Lynch (MER Quote) down 5.2%.

Marta notes that the big wild card for the credit markets is the ocean of derivative securities held by investment funds that are highly leveraged. Lending institutions are starting to demand cash on the money they loaned to these funds, which is driving them to liquidate their bond holdings. In a note to clients last week, JPMorgan Chase described the situation as a "systemic margin call."

"We're starting to see bid lists come around the street that are very obviously evidence of banks liquidating on hedge funds," says Marta. "The question is whether we can wind down this carnival of derivatives gambling that created an alternate universe without crushing the financial system that would intermediate real economic transactions."

So far, the Fed's efforts to calm financial markets have failed to bring the crisis of confidence in the credit markets to an end. While the Fed has lowered its fed funds rate target by 225 basis points since September, spreads have widened for mortgage lending rates as the declines in the U.S. housing market have steepened.

"They're cutting rates, but banks still aren't lending," says Len Blum, managing director with Westwood Capital. "Tight credit leads to more defaults which leads to tighter credit which leads to more defaults."

In this atmosphere, concerns about Fannie and Freddie have proliferated. The government agencies don't have the explicit full faith and credit of the U.S. government, but financial markets have long acted as though they do. With the U.S. housing market in a decline comparable to those last seen in the Great Depression, investors are now questioning the full extent of the government's backing.