Markets Wilt On Worries About Credit Woes

In Depth

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Stocks went into a tailspin in late trading Thursday. The Dow closed down 678.91 points, to 8579.19, marking the first time in five years that the benchmark index closed below 9,000. Exactly a year ago, the Dow was at its all-time high of 14,164. It has lost 39 percent since then.

The bulk of the sell-off happened in the last hour of trading as investors grew increasingly convinced that a global recession was inevitable. To now, most of their gloom had been centered on financial companies caught on the wrong side of the financial crisis. On Thursday, that concern spread to companies investors perceived vulnerable to the credit crunch the financial crisis has sparked.

GM Hit Hard

General Motors, one of the Dow's component stocks, was hammered. Its share price fell more than 30 percent after ratings agency Standard & Poor's said it had put the automaker on a watch list to possibly downgrade its credit rating.

That was enough to spook investors to drive down prices. The sell-off comes in spite of a roster of moves aimed at building investor confidence. Earlier this week, the Treasury announced that it would give credit markets a boost by buying short-term loans known as Commercial Paper. Businesses buy commercial paper to help with cash flow — they are like short-term IOUs that allow them to pay for raw materials or for payroll. The commercial paper market has dried up as banks have held onto the cash. The Treasury was trying to help. That did little to thaw the credit markets.

On Wednesday, the Fed announced a coordinated half-point interest rate cut with five other central banks. The thought was that making borrowing cheaper would free up credit. Instead it only seemed to rattle investors more. They couldn't decide if the rate cut was an indication that central banks were prepared to do whatever it took to prevent a global recession or whether it meant central bankers were trying to stave off something worse.

Will U.S. Invest Directly In Banks?

Thursday morning, U.S. investors woke to the news that the Treasury Department was considering taking ownership stakes in U.S. banks. NPR reported last week that Treasury Secretary Henry Paulson was weighing a plan in which the U.S. government would directly inject cash into struggling firms in exchange for an ownership share. The money to do that would be taken from the $700 billion financial rescue package Congress passed and President Bush signed last week.

Many economists have said a cash injection plan would be a better way to address the financial crisis than just taking distressed assets off their books at firesale prices. "These capital injections are something that Secretary Paulson is actively considering," said White House spokeswoman Dana Perino at a press conference Thursday.

All this was still not enough to get credit markets moving. The difference between what banks and the Treasury pay to borrow three-month money, the so-called TED spread, widened to 4.0 percentage points on Thursday, according to Bloomberg figures. That is biggest spread since Bloomberg began compiling data in 1984. To give an idea of just how much the financial crisis has affected credit — the Ted spread was 1.16 percentage points a month ago.

Thursday also marked the return of short sellers to the market following the expiration of a three-week Securities and Exchange Commission ban on short selling more than 950 financial stocks. Short sellers "borrow" shares that they expect to lose value and sell them. When the price does drop, they buy the now cheaper shares to pay back the ones they borrowed at the higher price — and make a profit on the difference. It is unclear what effect their return had on the markets.

Fed Gives AIG New Loan

After the market closed on Wednesday, the Fed announced that it decided to extend a second loan of nearly $38 billion to American International Group, the giant insurer that it had seized and rescued just last month. In exchange for an $85 billion loan, it took over AIG and fired its management.

The bailout was supposed to give AIG time to sell off its assets in an orderly fashion. Now, it seemed the $85 billion wasn't enough. AIG has already tapped $70.3 billion of the initial emergency loan issued three weeks ago. The decision to issue a second loan has raised questions about just how deep a hole AIG is in. In this second loan, the Fed will take some of AIG's highly-rated investment-grade securities and give the company cash.

While the securities AIG is borrowing are considered very safe, it still means the Fed is on the hook to AIG for as much as $123 billion. A Fed spokesman told NPR that AIG is just having the same credit crunch trouble as many other companies are having right now. No one wants to buy securities from anyone because everyone is hoarding their cash. Because of that, the Fed has had no choice but to become the lender of last resort.

Some investors worry that if the Fed underestimated the scope of AIG's problems, perhaps it has also undershot the mark with its $700 billion bailout package, and it will end up needing more money to rescue the financial industry. What it is important to remember, however, is that even if the government ends up spending more than $700 billion, it won't necessarily be a dead loss. That money will be going to shore up banks and to buy assets — and those assets will have some value. It just isn't clear right now what exactly that value will be.

With reporting by Dina Temple-Raston

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