Stocks Routed; Reality of Bailout Sinks In

The Dow and S&P lose 3%-plus, and the Nasdaq sinks 4% as the Treasury's bailout plan for financial firms does little to boost confidence.
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Stocks in New York tumbled through a dreary Monday, as traders continued to assess the Treasury Department's massive weekend bailout plan for financial firms. Money flowed into crude-oil futures, prompting a sharp spike in prices.

The

Dow Jones Industrial Average

shed 372.75 points, or 3.3%, to 11,015.69, and the

S&P 500

slipped 47.99 points, or 3.8%, to 1207.09. The

Nasdaq

gave back 94.92 points, or 4.2%, to 2178.98.

On Friday, the three major indices finished substantially higher. Financials led the rally after the

Securities and Exchange Commission

temporarily banned short-selling of 799 stocks in the sector. The Treasury announced over the weekend that it would iron out a plan to provide hundreds of billions of dollars to U.S. banks and brokerages to try to avert further damage from the credit crisis.

The

New York Stock Exchange

on Monday extended the short-selling ban to 30 more companies that have significant financial operations. The list includes

General Motors

(GM) - Get Report

and

General Electric

(GE) - Get Report

. GM shares fell 11% to $11.58, and GE lost 1.8% to $26.15.

The short-selling ban helped unwind the buy-commodities, sell-financials trade, Paul Nolte, director of investments at Hinsdale Associates, wrote in an email Monday. Friday's rally was largely due to a recovery from very low levels and illustrates recent market volatility. "As a result, it is hard to take the movements ... as much more than a bounce from severely depressed levels," he wrote.

Over the weekend, the

Treasury Department

drafted a plan to lift as much as $700 billion in bad debt from financial-sector balance sheets.

"Some of the tranches of these

securities are radioactive," said Jack Ablin, chief investment officer at Harris Private Bank. However, some of the less-risky securities do have value, he said. He said that the $30.6 million in mortgage-backed bonds Merrill Lynch sold to Lone Star in July were actually very solid.

"The fact that no one wants to touch this stuff with a 10-foot pole is hurting the market value of stuff that no one wants to really understand," said Ablin. He said that if a bailout institution holds the troubled assets to maturity, there's reason for optimism.

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Nevertheless, it's possible that a government bailout institution

would actually overvalue the assets it buys. "There is a potential for conflict of interest there," said Ablin.

"While desperate times require desperate measures, this might be a bit too desperate," wrote Nolte. The government plan raises the limit of the national debt by $1 trillion, he wrote. "While there are few worries if the plan works, the proposal severely hamstrings the government to act on any other issue that may come up," and may increase government borrowing from creditors who already own a great deal of U.S. debt, he wrote.

Tony Crescenzi, chief bond market strategist at Miller Tabak and contributor to

RealMoney.com

, acknowledged the risk associated with a bailout of this size. "If global investors see little wisdom in the U.S. policy response and turn their backs on the U.S. then the U.S. will enter an extraordinarily dark period marked by rapid, massive and de-stabilizing deleveraging." However, he said that such an event is unlikely because the U.S. continues to produce innovative ideas, has a solid political system and a strong military.

In terms of the impact on fixed-income markets, Art Hogan, chief market strategist at Jefferies & Co., said that the yield curve for Treasuries will steepen as the government issues new debt to cover new obligations, driving bond prices down and yields higher.

On Sunday, the

Federal Reserve

said that

Goldman Sachs

(GS) - Get Report

and

Morgan Sanley

(MS) - Get Report

would become bank holding companies instead of investment banks. The change subjects the pair to increased government oversight and stricter capital requirements.

Goldman and Morgan

had been the final two large, independent brokerages after

Lehman Brothers

went bankrupt and

Bear Stearns

and

Merrill Lynch

(MER)

merged with large banks.

CNBC

subsequently reported that Morgan Stanley would probably not be merging with

Wachovia

(WB) - Get Report

following the

Fed's announcement

.

Separately, Japanese bank

Mitsubishi UFJ

(MTU)

announced early Monday it would buy a 10% to 20% stake in Morgan Stanley. Such an investment could be worth as much as $8.4 billion.

Goldman dropped 7% to $120.78, while Morgan Stanley ticked down 0.4% to $27.09.

"It was a surprise to me," said Ablin of the end of the investment-banking business model. He said that Goldman Sachs is now in competition with

Bank of America

(BAC) - Get Report

and

Citigroup

(C) - Get Report

. Ablin said that as Goldman and Morgan Stanley seek funding from wholesale deposits, their costs are going to be incrementally higher than those at Citigroup and Bank of America, which already have large deposit infrastructure and offset their costs with service charges.

The impact of the shift away from the investment-banking business model is deleveraging, said Jeffries' Hogan. "The boom and bust cycle ... is going to flatten out a little," he said. "We're going to get used to quieter profits and more stable profits. You're not going to see explosive growth, so we're not going to rocket out of the doldrums we've gotten ourselves into."

New York governor David Paterson said Monday afternoon that his state would try to regulate the $62 trillion credit-default swap market. Credit-default swaps are insurance against a firm defaulting on its loans and have been a focal point for financial firms during the credit crisis.

The Wall Street Journal

reported that shareholders in

AIG

(AIG) - Get Report

are searching for the means to raise capital to escape nationalization of the insurance giant. Shares rocketed 23% to $4.72.

Outside the financial sector, software maker

Microsoft

(MSFT) - Get Report

announced a $40 billion

share buyback

program and said it would raise its quarterly dividend to 13 cents from 11 cents. The stock added 1% at $25.40.

Similarly, computer maker

Hewlett-Packard

(HPQ) - Get Report

and athletic apparel developer

Nike

(NKE) - Get Report

each announced their own share-buyback programs. H-P skidded 2.3% to $47.16, and Nike lost 0.9% to $63.15.

Shifting to commodities, crude oil gained $16.37 to settle at $120.92 a barrel. Gold was adding $44.30 to finish at $909 an ounce.

Longer-dated U.S. Treasury securities were falling in price. The 10-year was down 8/32 to yield 3.84%, and the 30-year was down 18/32, yielding 4.41%. The dollar was declining sharply vs. its major foreign competitors.

Abroad, European exchanges were ticking downward. The FTSE in London and the DAX in Frankfurt were both falling. The Nikkei in Japan and the Hang Seng in Hong Kong had earlier finished their sessions on the upside.