The Federal Reserve couldn't help Wall Street, but government bailouts could. That's the message from investors when the stock market on Tuesday greeted a surprise three-quarter point rate-cut from the Fed with a major selloff, only to rebound Wednesday and crank out the biggest rally of the year on news that a lifeline may be in the works for the troubled bond insurance industry. Forget the highly touted "stimulus package" for consumers that's in the works in Washington, D.C. Talk of a bailout for MBIA ( MBI) and Ambac ( ABK) that's being orchestrated by Eric Dinallo, the top New York state insurance regulator, appears to be what finally lit a fire under stocks in a volatile session Wednesday. "No private investor in their right mind would touch this stuff, but someone has to step up and deal with it if we want to prevent a systemic event in the financial system," says T.J. Marta, fixed income strategist with RBC Capital Markets. The session began with a 326-point dropoff in the Dow Jones Industrial Average, building on a 128-point selloff on Tuesday -- a day when the Fed slashed its fed funds rate target by 75 basis points for the first time since 1982. The Fed's move smacked of a market-driven panic, but it also hinted of concerns at the central bank that go beyond the threat of a mere recession, which many observers say is probably already underway. Bernanke may have been looking at the same thing that sent investors in Asia and elsewhere into a tizzy on Monday, when U.S. markets were closed for the Martin Luther King Jr. holiday -- a ratings downgrade on Ambac, announced Friday by Fitch Ratings and the threat of more downgrades to come. As the largest bond insurers at the heart of the U.S. financial system, MBIA and Ambac have insured roughly $2.5 trillion in outstanding debt. Meanwhile, spiking mortgage foreclosures and consumer loan defaults have resulted in huge losses for both companies, calling their Triple-A credit ratings, which are essential for their survival, into question. On Friday, Ambac said it was abandoning its plans to raise $1 billion, a day after Moody's Investor's Service threatened a credit downgrade. Fitch responded with a downgrade, and more such actions from Moody's and Standard & Poor's seemed likely. That raised the specter of a massive wave of wealth destruction in a global financial system that is flooded with illiquid and opaque derivative securities whose value depends on ratings supported by the insurance industry. "If one of those bond insurers fails, you're going to see a whole new round of losses," says Marta. Amid the Wednesday morning selloff, a report circulated in the credit markets from analysts at UniCredit SpA, Italy's largest bank, arguing that a government bailout plan for the bond insurers would likely be forthcoming. "A kind of bailout supported by monetary authorities or governments is the only chance for the industry to survive,'' said the report. "This bailout seems to be highly likely given the important role of bond insurers in the current market environment." Those sentiments had MBIA and Ambac shares rallying big for their second-straight session. Then, the New York Insurance Department announced that regulators met with banks to discuss ways of stabilizing the bond insurers and bringing in additional capital and capacity to their business. MBIA closed the day up 32.6%, while Ambac rocketed up 71.9%. The banking sector led gains in the market, with Bank of America ( BAC) closing up 8.5%, Merrill Lynch ( MER) adding 6.6% and Citibank ( C) ending up 8%.
Elsewhere in the public sector, President Bush told reporters he was confident that Congress could pass a stimulus package with tax relief for consumers in an effort to head off recession and Senate Banking Committee Chairman Christopher Dodd reportedly proposed a federal program to buy "very distressed" mortgages at steep discounts as part of economic stimulus legislation being developed in Congress. Longtime Wall Street favorites Google ( GOOG) and Apple ( AAPL) lost 6.1% and 10.6% respectively on the day, but the Dow swung to a 299-point gain in the last hour of trading, up 2.5%. The S&P 500 closed up 2.4% and the Nasdaq Composite capped off a dramatic turnaround, adding 1% after being almost 4% earlier. Amid all the discussion of government rescue plans, the Congressional Budget Office provided a dose of cold water, estimating that the federal deficit for the current budget year will jump to about $250 billion after three years of declining shortfalls that never fell below $163 billion. Even worse, the nonpartisan congressional number-cruncher isn't even predicting the recession that many forecasters now expect on Wall Street. Its estimate doesn't include the stimulus package, which will likely cost the Treasury well over $100 billion -- let alone economic aid for troubled borrowers. With all that spending along with Democrats favored to take back the White House in November, the long-term outlook on Wall Street includes higher taxes along with recession. "A substantial reduction in the growth of spending, a significant increase in tax revenues relative to the size of the economy, or some combination of the two will be necessary to maintain the nation's long-term fiscal stability," said CBO Director Peter Orszag in testimony before the House Budget Committee.