Stocks Plunge as Lehman Collapses

The U.S. stock market was hammered early Monday after Lehman Brothers filed for a historic bankruptcy and Merrill Lynch agreed to be bought by Bank of America.
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Updated from 10:13 a.m. EDT

U.S. stocks were getting pummeled Monday after

Lehman Brothers

(LEH)

set plans for a historic bankruptcy and

Merrill Lynch

(MER)

agreed to be bought by

Bank of America

(BAC) - Get Report

, sparking new worries that the credit crisis isn't yet close to being resolved.

The

Dow Jones Industrial Average

was losing 210 points to 11,212, and the

S&P 500

was sinking 21 points to 1230. The

Nasdaq

was slumping 29 points to 2232.

The start of 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.

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. 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

Barclays

(BCS) - Get Report

to keep it afloat,

Lehman

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 Fed also expanded its lending to Wall Street firms to help deal with Lehman's Chapter 11 filing. A consortium of banks including

JPMorgan

(JPM) - Get Report

,

Goldman Sachs

(GS) - Get Report

and

Citigroup

(C) - Get Report

created a $70 billion fund to further bolster liquidity in financial markets.

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 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

(AIG) - Get Report

grasped for solutions to their subprime exposure.

Unlike Lehman,

Merrill

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.

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,

AIG

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 and could apply additional pressure to the stock, which was already hit for more than 30% of its value during Friday's trading.

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. Separately,

Kohlberg Kravis Roberts

and

TPG

offered to support AIG with fresh capital pending a bridge loan to AIG from the Fed.

"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 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.

Away from the financial-sector shakeup, the price of crude oil was down $4.52 to $96.66 a barrel. Gold was climbing $12.50 to $777.

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 1-13/32 to yield 3.55%, and the 30-year was surging 1-15/32 to yield 4.23%. The dollar was rising vs. the euro, was slightly weaker against the pound and was plummeting against the yen.

Overseas exchanges were mainly trading lower, especially in Europe. The FTSE in London and the DAX in Frankfurt were each recently down more than 3.5%.