Stocks Dive More Than 4% on Credit Fears

The Fed's bailout of AIG does nothing to soothe investor fears, and the Dow surrenders 450 points. The Nasdaq plummets more than 100 points. Get Frank Curzio's take in The Real Story.
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Updated from 4:04 p.m. EDT

U.S. stocks took another steep dive Wednesday after the

Federal Reserve

agreed to take over insurance giant

AIG

(AIG) - Get Report

and the financial sector was clubbed by new fears about credit.

The

Dow Jones Industrial Average

, just two days after shedding 504 points, fell 449.36 points, or 4.1%, to 10,609.66. The

S&P 500

slumped 57.20 points, or 4.7%, to 1156.39, and the Nasdaq tumbled 109.05 points, or 4.9%, to 2098.85.

Worries about the financial sector were central to the day's massive declines. After trading closed Tuesday, the

Fed

reversed its earlier decision and agreed to offer

AIG

(AIG) - Get Report

an $85 billion bridge loan to bail out the company. In exchange, the government will essentially get a 79.9% equity position in AIG and will charge a hefty interest rate.

Treasury Secretary Henry Paulson also stipulated that AIG CEO Robert Willumstad leave the company. Edward Liddy, former CEO of

Allstate

(ALL) - Get Report

, will replace Willumstad. AIG shares dropped 45% to $2.05.

"I think the problems at AIG are just so deep and so extensive that it was beyond the private sector to take care of it," said Maryann Hurley, vice president of fixed income trading at DA Davidson. After

Bank of America's

(BAC) - Get Report

acquisition of Countrywide and

Merrill Lynch

(MER)

, she said, the private sector would have a hard time swallowing AIG. The choice was to either bail out AIG or allow it to fail, which would have badly shaken the financial system, she said.

However, the AIG bailout doesn't mean the crisis is over. "It would be, I think, not prudent to believe that there aren't other problems out there," said Hurley.

"What the government is telling you is, if you're going to fail, fail massively," said Matthew Smith, vice president and portfolio manager at Smith Affiliated Capital. Smith said that unlike in previous market busts in 1987 and 2000, which were largely tied to stocks themselves, the current market downturn is based in derivatives contracts, making losses more difficult to recoup. In this environment, "If your money goes bust, it explodes like a firecracker," he said.

Smith said that now that the government has bought an insurance company, the question is what company will get bailed out next. "The moral hazard has just gone out the window at this point," he said. "You woke up this morning, and now you and I are the new owners of an insurance company. That's the scam that's being played here."

Earlier in the week, brokerage

Lehman Brothers

(LEH)

filed for bankruptcy and Bank of America staged a last-minute acquisition of Merrill Lynch. Fearing AIG may be next, investors sold the stock down 60% on Monday, then dropped it another 21% on Tuesday.

Late Tuesday, investment bank

Morgan Stanley

(MS) - Get Report

reported profits

that declined 7.7% year over year but beat expectations. Morgan Stanley had been facing pressure as other financial firms buckled.

During Wednesday's session, traders were focusing on both Morgan Stanley and

Goldman Sachs

(GS) - Get Report

, which reported earnings early Tuesday.

CNBC

's Web site reported late Tuesday that Morgan may pursue a partnership in the wake of declines in its stock price. Shares of Morgan Stanley dropped 26%, to $21.18, while Goldman lost 14% to $114.50.

Seattle bank

Washington Mutual

(WM) - Get Report

was also under pressure following a report in the

New York Post

that federal regulators were attempting to shop WaMu to

Wells Fargo

(WFC) - Get Report

or

JPMorgan

(JPM) - Get Report

.

WaMu

secured a waiver of an anti-dilution clause from

TPG

, a private-equity firm that holds shares of WaMu. Under the clause, WaMu would have had to pay TPG for dilution of share value stemming from a capital raise. The waiver removes a significant obstacle to WaMu's efforts to shore up its balance sheet or merge with a stronger partner. Shares finished down 13% at $2.01.

Elsewhere, British bank

Barclays

(BCS) - Get Report

announced it would buy Lehman's North American businesses. Barclay's lost 2.4% to $22.60.

Also this morning, the

Securities and Exchange Commission

banned "abusive"

naked short-selling

on all publicly traded companies. The ban takes effect 12:01 a.m. EDT Thursday. Naked short-selling can be used to artificially pressure stock prices. Some market observers have pointed to naked shorts as a means to exploit the fearful credit environment for profit while depleting companies' capital levels.

Separately, Democratic and Republican lawmakers have floated the idea of developing a resolution trust similar to the one created during the savings-and-loan crisis of the 1980s. The government trust would help sort through the securities that contributed to the fall of

Bear Stearns

, Lehman,

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

.

The Treasury also announced Wednesday that, in an effort to bolster its own balance sheet as it works to provide liquidity to the market, the

Federal Reserve

would initiate the sale of additional Treasury notes, starting with a $40 billion auction of 35-day government debt securities.

At the beginning of the year, the Fed had nearly $800 billion in Treasuries. Following commitments including the $200 billion it allocated to the Term Securities Lending Facility the $85 billion loan to AIG, the Fed's holdings will soon be depleted to $195 billion.

The allocation of the Fed's capital to the financial sector marks the largest cash infusion to the private sector by the central bank since the Great Depression.

In the technology sector, memory-chip maker

SanDisk

(SNDK)

rebuffed a $5.8 billion buyout bid by

Samsung Electronics

, saying Samsung has undervalued its business. SanDisk shares skyrocketed 39% to $20.92.

As for commodities, crude oil added $6.01 to settle at $97.16 a barrel, and gold soared $70 to $850.50 an ounce.

In terms of economic data, the Energy Information Administration reported that crude inventories shrank by 6.3 million barrels during the week ended Sept. 12, a wider decline than the 3.7 million-barrel decline economists had expected.

The Census Bureau reported that building permits in the U.S. fell 6.2% to an annual rate of 895,000 -- a 17-year low -- in August. Economists were expecting a more modest decline to a rate of 925,000. Housing starts also dropped to 895,000, shy of analysts' forecasts for 950,000 new homes.

Longer-term U.S. Treasuries were rising. The 10-year was up 14/32 to yield 3.38%, and the 30-year was gaining 14/32, yielding 4.07%. The dollar was falling vs. the yen but inching up against the euro and pound.

Overseas, European exchanges were lower, as the FTSE in London and the Dax in Frankfurt took losses. The Nikkei in Japan closed higher, while Hong Kong's Hang Seng finished on the downside.