Dow Drops 500 Points as Wall Street Reels

Lehman Brothers' bankruptcy filing, BofA's deal to acquire Merrill, and AIG's call for funding sparked a global sell-off Monday. What will Tuesday bring?

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By BusinessWeek, Associated Press, and Action Economics staff

With selling accelerating in the final hour of trading, major U.S. stock indexes suffered their worst percentage losses in nearly six years Monday, with the blue chip Dow Jones industrial average diving over 500 points.

On Monday, the Dow Jones industrial average tumbled 504.48 points, or 4.42%, to finish the session at 10,917.51, ending below the psychologically significant 11,000 level. The broader S&P 500 index plunged 57.98 points, or 4.63%, to 1.193.72, breaking below its July lows. The tech-heavy Nasdaq composite index sank 81.36 points, or 3.60%, to 2,179.91.

Market breadth was overwhelmingly negative. On the New York Stock Exchange, 30 stocks declined in price for every one that advanced. The ratio on the Nasdaq was 24-3 negative. Trading was active, reports S&P MarketScope.

European markets stumbled, though they finished above session lows. London stocks were off 3.87%, Frankfurt was off 2.74% and Paris was down 3.78%. Asian markets were closed for holidays.

The rout capped a global sell-off after a cataclysmic chain of events for major Wall Street firms over the weekend, raising concerns about the health of financial markets. Investment bank Lehman Brothers (LEH) filed for bankruptcy protection, while rival Merrill Lynch (MER) agreed to be taken over by Bank of America (BAC) and the Federal Reserve threw a lifeline to the battered financial industry. Shares of troubled insurer American International Group (AIG) plummeted as the firm asked for financial help from the Fed.

According to a Wall Street Journal report late Monday afternoon, the government obliged -- sort of -- by asking Goldman Sachs (GS) and J.P. Morgan Chase (JPM) to lead a $70 billion-$75 billion lending facility for AIG.

U.S. Treasuries surged Monday as investors sought the relative safe haven of government debt amid speculation that global central banks might do a coordinated rate cut. The Federal Reserve's next scheduled policy meeting is on Tuesday.

Gold futures were higher, as was the dollar index. Oil futures were off as Hurricane Ike caused limited damage to energy installations in the Gulf of Mexico.

At the end of Monday's session, investors were left with more questions than answers.

"Can Lehman's positions be unwound in an orderly fashion? Will the resulting downward pressure on asset prices force others to recognize further losses of their own? What will be the impact of a possible round of asset liquidation by AIG and possibly others? Are there other firms in dire straights that have not yet hit the radar screen? And how will investors react in the face of such unknowns with headlines screaming of crisis?" asked David Joy, chief market strategist for RiverSource Investments, in a note Monday.

The financial sector, save for Merrill Lynch, took a terrible pounding after the weekend's drama. AIG plummeted 61%, Bank of America was down 21%, Washington Mutual (WM) fell 27% and Wachovia (WB) skidded 25%.

Other financial firms posted smaller, though still painful declines: Citigroup (C) was down 15%, Morgan Stanley (MS) fell 14%, Goldman Sachs (GS) shed 12%, and JPMorgan Chase (JPM) lost 10%.

Merrill shares, after being sharply higher much of the day on the merger news, fell back to finish nearly unchanged as the BofA stock to be used in the acquisition of the firm plummeted.

Lehman shares sank to 21 cents after its bankruptcy filing.

Market volatility was elevated Monday. The VIX (S&P 500 market volatility index), a widely followed fear gauge for the stock market, was up 20% to 30.81.

"A VIX well north of 30, possibly above the 35 level we think would do a lot toward showing some real fear and panic in the options market. We believe that until we get some real panic in the majority of the sentiment readings, a real bottom to this bear market is unlikely," wrote S&P chief technical strategist Mark Arbeter in a note Monday.

"The news today was very bad, and the lack of any recovery in stocks or downturn in Treasuries indicates the financial markets don't believe the worst is over," wrote S&P MarketScope analysts.

Meanwhile, officials were scrambling to calm nervous investors. President Bush sought to assure Americans about the markets in a statement Monday.

Treasury Secretary Henry Paulson said in remarks Monday that the U.S. is working through a "difficult time," adding that Americans can have confidence in the markets. He reminded that the housing market has been the root of the economic challenges, and said the moves taken by the Fed, SEC, and Treasury have helped minimize the disruptions. He was impressed at how the financial institutions came together. Regarding commercial banks, he said the banking system is a "safe and sound one" and Americans can be "very confident" in U.S. banks.

There was speculation the Federal Reserve, European Central Bank, and Bank of England would make coordinated rate cuts amongst the major central banks and take new liquidity measures.

"A rate cut at tomorrow's [FOMC] meeting has increased in likelihood, but would probably be done only in combination with the ECB," says S&P chief economist David Wyss.

"We still don't believe a rate cut is the appropriate solution to the current financial crisis, and indeed we suspect many at the Fed are of similar opinion. And if the markets stabilize somewhat by tomorrow, and stocks recover, policymakers are likely to leave rates on hold and address the issue with its policy statement," wrote Action Economics analysts Monday.

European Central Bank president Jean-Claude Trichet said the bank must be "extraordinarily alert" on the financial-market environment. He added that that "it is an ongoing market correction" with episodes of a high level of volatility. The ECB earlier Monday alloted 30 billion euros in extra funds to ease market liquidity as interbank rates jumped higher.

Meanwhile, China cut its benchmark interest rates and required reserves.

The Fed also did its part to keep the markets running more or less smoothly, announcing measures to add liquidity, including allowing all investment grade debt securities to be used for the TSLF schedule two auctions, which will now be held every week instead of every two weeks.

Still, credit market conditions were dicey. The Federal reserve moved massive liquidity into the financial system with an injection of $70 billion, with the Fed funds rate trading at 6%, three times the current funds rate target. "It ... looks like the $70 billion in repos this morning is loosening up the funds rate, which as dipped back to 4%," according to Action Economics.

More liquidity measures were also announced by a consortium of banks including Bank of America, Barclays, Citibank (C), Credit Suisse (CS), Deutsche Bank (DB), Goldman Sachs (GS), JP Morgan Chase (JPM), Merrill Lynch, Morgan Stanley (MS), and UBS (UBS) to maintain trading relationships and credit terms, to establish a $70 billion collateralized borrowing facility and to "facilitate an orderly resolution of OTC derivatives exposures between Lehman Brothers and its counterparties."