Stocks Sway in Final-Hour Recovery

Updated from 3:11 p.m. EDT

Stocks on Wall Street were trading with extreme volatility in the final hour of trading Friday afternoon, briefly swinging into positive territory from heavy losses. At the center of the whipsaw trading was the fate of the financial system, which has been buckling as credit markets remained frozen and financial firms got pummeled.

The Dow Jones Industrial Average plummeted nearly 696 points early and briefly broke below the 8000 level, only to recover just as sharply and briefly touch positive territory. After another swoon and recover, the Dow was lately down just 3 points at 8575. The S&P 500 was down a point at 908. The Nasdaq was 6.4 points higher at 1651.

Amid the increasing concern about banks, the U.S. government was considering guaranteeing bank debt and insuring all domestic bank deposits, according to a report in The Wall Street Journal.

Friday afternoon, the finance ministers from the Group of Seven industrial nations held a meeting in Washington. The economic powers plan to discuss a coordinated response to the global credit crisis. Japan's finance minister, Shoichi Nakagawa, said that his country would propose an international fund to secure emergency loans for nations suffering under the credit squeeze.

"Because this is a global banking crisis, you've got to come up with a global plan to backstop everyone," said Paul Mendelsohn, chief investment strategist at Windham Financial. "This is a real financial panic. The run on the money markets is the equivalent of a run on the bank."

He said the U.S. Treasury should begin guaranteeing money market funds and is right to take equity positions in financial firms as opposed to buying bad debt.

Mendelsohn said the situation isn't hopeless, and the G7 meeting is an opportunity to fix the system. "They've got to come up with a plan on Monday," he said. "Everybody's got to know what the rules are, how the system's going to work moving forward. You have to throw as much money as it takes."

Traders were closely eying an auction of credit default swaps related to bankrupt brokerage Lehman Brothers. The auction is expected to bring heavy losses to sellers of the swaps, which function as insurance against a default on company debts. The market for these derivatives has been tied up as credit markets showed at best a mixed reaction to internationally coordinated rate cuts initiated earlier in the week.

The final settlement price for the Lehman credit default swaps came in at 8.625 cents, meaning that sellers of Lehman CDS will have to pay buyers 91.375 cents on the dollar, a higher payment than expected.

"The Lehman auction could turn things around," said Paul Nolte, director of investments at Hinsdale Associates. "What has to enter the market, I think, is some level of trust. And right now, there isn't." He said that seeing the Lehman credit-default swaps clear will help get the financial system moving again.

Lehman's bankruptcy triggered the crisis, said Mendelsohn. "When the Lehman commercial paper failed, that's what caused the run on money markets," he said.

Three-month dollar Libor, a measure of the rates banks charge one another for large loans, climbed to a new high of 4.82%, although rates on the nine- and 12-month maturities were declining. The cost of overnight borrowing, which has been highly volatile in recent weeks, declined by more than half, to 2.47% from 5.09%.

Speaking in Washington, President Bush said the administration has taken significant steps to provide liquidity to the markets and that Americans should be confident about the U.S. economy's future. Bush also said that over time, steps already taken by the government would gain traction.

Financial stocks were at the forefront of investor skepticism thanks to nearly dry credit markets.

Battered firms Morgan Stanley ( MS) and Goldman Sachs ( GS) were again in focus. Ratings agency Moody's said it may cut Morgan Stanley's credit rating, and lowered its credit outlook for Goldman to negative. Both stocks were posting sizeable double-digit losses.

Following a heated battle with Citigroup ( C), Wells Fargo ( WFC) appeared set to buy Wachovia ( WB) unencumbered.

Citigroup said it will continue to pursue $60 billion in damages for breach of contract but would not try to overturn a merger between Wells Fargo and Wachovia. Citi had announced a Wachovia acquisition on Sept. 29, only to trumped days later by a new bid from Wells.

The Journal also reported that insurance firm AIG ( AIG) took out an additional $9 billion in government loans, bringing its total borrowing from the U.S. in the past three weeks to $70.3 billion. The company continues to attempt to sell its assets in a struggle to stay afloat.

The paper also said the U.S. exchanges are considering a temporary plan that would halt short-selling in any stock that had a drop of 20% in a single session. If that occurs, in many cases shorting would be banned in the stock for three days, the paper reported, citing people with knowledge of the matter.

Bank of America ( BAC) shares were edging higher following reports that it may sell a portion of its 11% stake in China Construction Bank. The banking titan also appeared set to carry out its acquisition of Merrill Lynch, despite declines in both firms' stock prices, according to a report in the Financial Times.

Earnings season continued amid the financial turmoil, as industrial bellwether General Electric ( GE) reported third-quarter earnings that declined 12% year over year but were in line with revised estimates.

As for analyst actions, Wells Fargo, along with insurance and credit services firms such as State Auto ( STFC), Erie Indemnity ( ERIE), Donegal Group ( DGICA) and Advanta ( ADVNB) all caught upgrades from Stifel Nicolaus.

Looking at economic data, the Census Bureau's report on the trade balance for August showed a deficit of $59.1 billion, whereas the economy registered a $62.2 billion deficit in July. Economists had anticipated an August deficit of $59 billion. The Bureau of Labor Statistics also reported that export prices excluding agricultural goods declined 1% in September. Import prices excluding oil dropped 0.9%.

In commodities, crude oil lost $8.89 to settle at $77.70 a barrel. Gold lost $27.50 to close at $859 an ounce.

Longer-dated U.S. Treasury securities were falling. The 10-year was down 22/32 to yield 3.87%, and the 30-year was declining 20/32, yielding 4.14%. The dollar was climbing vs. the euro and pound, but falling against the yen.

Overseas, European markets were taking it on the chin. The FTSE in London and the DAX in Frankfurt were each down more than 7%. In Asia, Japan's Nikkei and Hong Kong's Hang Seng also closed with broad losses.

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