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U.S. stocks plummeted Monday, with the Standard and Poor's 500 taking its steepest dive since the Sept. 11, 2001, attacks.
This time, however, Wall Street's wounds were self-inflicted. The subprime mortgage crisis appeared to lay claim to at least two major financial institutions and seemed poised to take down a few more.
The Dow Jones industrial index closed Monday down more than 500 points at 10,917.51. The S&P closed down 59 points at 1,192.70, the lowest level since October 2005.
The carnage in the markets came in the first U.S. trading since investors found out that the nation's largest brokerage, Merrill Lynch, had to sell itself to Bank of America just to stay afloat, and the U.S.'s fourth-largest investment bank, Lehman Brothers, would be forced to file for Chapter 11 bankruptcy. Lehman Brothers' stock had plunged 94 percent by the end of the day.
'Rough Spots Along The Road'
Speaking to reporters, Treasury Secretary Henry Paulson tried to put the best face on what had transpired. He said an "archaic" regulatory system was to blame for the turmoil in the markets.
Critics are harsher. They say that reckless lending practices by Wall Street firms during the housing boom are now coming home to roost.
Paulson said until the slump in U.S. housing prices levels off, "we're going to continue to have turmoil in the financial markets." He didn't sound hopeful about the slump ending anytime soon.
"I believe that there is a reasonable change that the biggest part of that housing correction can be behind us in a number of months," Paulson said, adding, "I'm not saying two or three months, but in months as opposed to years." He warned that there would be some "real rough spots along the road."
Paulson and other Treasury and Federal Reserve officials traveled to New York City over the weekend to huddle with Wall Street bankers in an effort to try to smooth those rough spots. The goal was to keep Merrill and Lehman afloat after the two institutions reported billions in losses related to mortgage-backed securities.
The plan had been to arrange some sort of shotgun wedding like the one they engineered for Bear Stearns earlier this year. In that case, the government provided some guarantees against losses, and JPMorgan Chase got Bear Stearns at a bargain-basement price.
The sessions over the weekend were only partly successful. Merrill agreed to sell itself to Bank of America for $50 billion so it could avoid bankruptcy, but Lehman was not so fortunate.
Both Barclays Bank and Bank of America flirted with the investment bank but in the end said that without some sort of guarantee that would shield them from additional losses, they were not willing to take the plunge. Without a white knight, Lehman was forced to file for bankruptcy on Monday. Lehman has some $60 billion in bad real estate debt.
"The situation and facts around Bear Stearns are very, very different," Paulson said when asked why the government wouldn't extend the same sort of guarantees against losses for Lehman as it had for Bear Stearns. "I never once considered putting taxpayer dollars on the line in the Lehman situation."
'At Some Point You Have To Say No'
Wall Street Journal economics editor David Wessel told Renee Montagne Monday morning that the federal government didn't come to Lehman Brothers' aid because of the barrage of criticism it got for saving Bear Stearns, which put some $30 billion of taxpayer money at risk.
"It realized that at some point you have to say no or the entire financial system, every time there's a problem, is going to come to the Federal Reserve and the taxpayers and say 'we need your help here,' " Wessel said.
So Paulson, Federal Reserve Chairman Ben Bernanke and New York Fed President Tim Geithner decided to draw a line in the sand, "and now we're going to find out if they did the right thing or not," Wessel said.
"If things start to get better now, it will be seen as the right decision. If they made a mistake and they should've put taxpayer money into this, they'll go down in history as the guys who made the biggest blunder since 1930."
To provide some sense of scale of the crisis: Merrill Lynch — one of the country's top issuers of mortgage-backed securities — reported it had lost more than $45 billion on its mortgage investments. That's about two times more than all of its profits in the two years before the subprime mortgage crisis. So far, financial institutions around the world have written off hundreds of billions of dollars in losses related to mortgage-backed securities.
Now all eyes are on insurer American International Group. The government announced Monday afternoon that it would not bail out the company or provide the guarantees it needed to stay afloat. It is pressuring a consortium of investment banks to do so, but it is unclear whether that will work.
New York Gov. David Paterson announced that the State of New York would allow AIG to shift some $20 billion in assets to shore up its balance sheet. Investors didn't seem to think that would be enough. AIG traded Monday for as low as $3.50 a share — a far cry from its 52-week high of $70.13 a share.
President Bush tried to calm investors' jangled nerves during a press conference at the White House on Monday as well. He said he had been in close touch with Paulson throughout the weekend and added that he knew Americans were concerned about the financial markets. He said his administration was working to reduce further disruptions and any impact the credit crisis would have on the broader economy.
"In the short run, adjustments in the financial markets can be painful," the president said. "Both for the people concerned about their investments and the employees of the affected firms. In the long run, I am confident our capital markets are flexible and resilient and can deal with these adjustments."
For many investors, the failure of Lehman is particularly sobering. It was a venerable 158-year-old firm that managed to survive everything from the railroad bankruptcies of the 1800s to the collapse of the Long-Term Capital Management hedge fund 10 years ago.
The question swirling in the markets is, "Who's next?" The nation's largest savings and loan, Washington Mutual, has been under pressure. But there were no announcements about that institution Monday.
Brokerages that fail usually are handled by the Securities Investor Protection Corp., which appoints a trustee to liquidate the business and protect its customers. It is unclear how Lehman's customer accounts will be handled. They could be farmed out to other firms that could protect cash and securities. That's what happened when failed junk-bond firm Drexel Burnham Lambert filed for bankruptcy in 1990.