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Financials Slam Stocks; Dow Plunges 500 Points

The Dow and S&P sink more than 4.4% after Lehman Brothers files for a historic bankruptcy, Merrill Lynch agrees to be bought by Bank of America and AIG tries to cover its subprime bets. See Frank Curzio's take in The Real Story (above).
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Updated from 4:12 p.m. EDT

The U.S. stock market suffered tremendous losses Monday after

Lehman Brothers


set plans for a historic bankruptcy and

Merrill Lynch


agreed to be bought by

Bank of America

(BAC) - Get Free Report



Dow Jones Industrial Average

dropped a staggering 504.48 points, or 4.4%, to 10,917.51, its worst single-day pullback since the market reopened six days after the terrorist attacks of Sept. 11, 2001. The

S&P 500

sank 58.74 points, or 4.7%, to 1192.96. The


slumped 81.36 points, or 3.6%, to 2179.91.

The start of Monday's trading followed a very busy weekend on Wall Street, as CEOs of major financial firms met with government officials in an attempt to patch the worst holes in the system.

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At the center was Lehman. The brokerage had been sweating it out all last week, its stock declining 77% as fears about its future viability increased and a potential capital infusion by

Korea Development Bank

fell through.

After failing over the weekend to negotiate a deal with either Bank of America or


(BCS) - Get Free Report

to keep it afloat,


said early Monday it would instead file for Chapter 11 bankruptcy protection.

As it did, Lehman said its broker-dealer subsidiaries will continue operating such that customers will continue to trade or otherwise operate their accounts. The

Federal Reserve

also expanded its lending to Wall Street firms to help deal with Lehman's bankruptcy. A consortium of banks including


(JPM) - Get Free Report


Goldman Sachs

(GS) - Get Free Report



(C) - Get Free Report

created a $70 billion fund to further bolster market liquidity.


reported Monday that Lehman was in discussions to sell its investment management business to private equity companies including

Bain Capital


Clayton Dubilier and Rice


Hellman & Friedman

. Shares fell 94% to 21 cents.

Lehman's Chapter 11 filing is the largest in U.S. history in terms of total assets pre-filing. However, line items in the Lehman filing that leave its broker-dealers out of bankruptcy are a crucial barrier against the failure dragging down other firms, said James Paulsen, chief investment strategist at Wells Capital Management.

Paulsen said the Fed has created a moral hazard by backstopping JPMorgan's acquisition of Bear Stearns, allowing companies to wait for federal backing rather than trying to raise capital in the private sector.

"Because we put a public band-aid on this, we stretched the sucker out," he said. Although seeing financial firms go under is painful, "It might be better to 'burn baby burn' today than to deal with another bailout," he said.

As a result of Bear Stearns, "everybody wants a buyout," said Paulsen. Troubled institutions such as


(AIG) - Get Free Report

and Lehman would have felt more urgency to raise capital if the Fed had let Bear fail, he said. "In some perverse sense, the best that can happen is

that the Fed ... do the minimal amount possible," he said. Paulsen said that easing interest rates would be a good way for the Fed to offer support to the system without offering bailouts to individual firms.

At the same time, brokerage Merrill Lynch and insurance firm AIG grasped for solutions to their subprime exposure.

Unlike Lehman,


escaped the worst of Wall Street's wrath through an all-stock merger with Bank of America. BofA is buying the firm for $29 a share, or $50 billion. Federal regulators had become concerned that, after Lehman, Merrill could be one of the next large Wall Street firms to falter under credit fears. Merrill was up fractionally at $17.06.

It also was a tough weekend for AIG, which has gotten caught up in the recent financial storm by insuring subprime loans. As it faced the possibility of credit downgrades from ratings agencies,


scrambled to amass $40 billion on top of the $20 billion it's already raised this year.

Late Friday, Standard & Poor's warned that it may cut AIG's credit rating, a move that would make it more difficult for the insurer to borrow. AIG rejected a cash infusion by

J.C. Flowers

and other private equity companies because the deal would have granted the firms the possibility of taking over AIG. AIG elected instead to seek $40 billion in capital from the Federal Reserve, according to a report in

The New York Times


Speculation circulated on Wall Street that the company would sell assets including its American General Finance consumer-lending unit or International Lease Finance, its aircraft leasing business. New York Governor David Paterson said the state would permit AIG to effectively give itself a bridge loan as it tries to shore up its balance sheet. AIG would use assets from its subsidiaries to secure the required capital. AIG shares were recently down 50%.


reported Monday that the New York Federal Reserve was holding a meeting among representatives of the Treasury Department , financial services institutions and state officials about the fate of AIG.

The Wall Street Journal

said that the New York Federal Reserve would not offer a bridge loan to AIG. The Federal government, meanwhile, was recruiting Goldman and JPMorgan to develop a lending facility to help AIG raise capital. Shares were in a free fall, losing 61% to $4.76.

"I think AIG is going to be fine. It's got deep pockets," said Paulsen. "They're just adjusting to the idea of how much they have to pay to raise capital," he said. If the Fed lowers interest rates, he said, AIG will be able to raise funds.

Phil Dow, director of equity strategy at RBC Dain Rauscher, said that heavily levered owners of bad assets make it hard to know how dire the credit crisis is. However, he said that industry and government efforts to stem the downturn offer reason for hope.

"The problem is we don't know about valuations, we don't know about earnings, we don't know about continued subprime writedowns," said Dow. He said that if current earnings estimates are correct, then the market is fairly valued, but "my guess is this is going to take a long time for markets to reach an equilibrium."

Dow said that recent news events are of comparable size to events in 1929 and 1987, two years in which the markets crashed. He also said that assets of financial firms remain hard to value. "It doesn't feel right to me to think the worst is over right now," he said. "All the uncertainty has sort of wrung out any willingness to buy."

Bruce Bittles, chief investment strategist at R.W. Baird, said that pessimism in the market may have provided a buying opportunity, "although we're not ready to pull the trigger just yet." He said that he prefers to trade the market technically in this environment, and would look for the CBOE's volatility index to rise above 30, a CBOE put-call ratio above 150% for several days and a substantial increase in composite volume on the

New York Stock Exchange


Because the stock market is a leading indicator, Bittles said, he's looking for a technical bottom rather than looking for fundamental indications that the credit crisis has cleared up.

Skittishness about the financial sector extended to other firms, as well.


(WB) - Get Free Report

shares dropped 25% to $10.71.

Washington Mutual

(WM) - Get Free Report

took a 27% hit to $2. Goldman Sachs, Citigroup and Morgan Stanley each lost more than 12%.

Away from the financial-sector shakeup, the price of crude oil settled down $5.47 to $95.71 a barrel. Gold climbed $22.50 to $787.

As for economic data, the New York Fed said its Empire State manufacturing survey for September declined 7.4 points, whereas economists were expecting a 1.4-point uptick.

The Fed also released its capacity utilization and industrial production figures for August. Capacity use came in at 78.7%, down a percentage point from the July reading and short of analyst expectations of 79.6%. Industrial production declined 1.1% for August, down from a 0.1% increase in July and a wider loss than the 0.3% anticipated by analysts.

Longer-dated U.S. Treasury securities were soaring in price. The 10-year note was up 2-10/32 to yield 3.44%, and the 30-year was surging 3-30/32 to yield 4.09%. The dollar was falling vs. the euro, yen and pound.

Overseas exchanges were mainly trading lower, especially in Europe.