The Fall of the Financial Markets

The crumbling of the U.S. financial markets have begun. Tragic yet not a surprise.

September 18, 2008
Stocks Slump as Investors Run to Safety
By VIKAS BAJAJ
The financial crisis entered a potentially dangerous new phase on Wednesday when many credit markets stopped working normally as investors around the world frantically moved their money into the safest investments, like Treasury bills.

As a result, the cost of borrowing soared for many companies, while the stocks of Wall Street firms like Goldman Sachs and Morgan Stanley that only a couple of weeks ago were considered relatively strong came under assault by waves of selling. Investors were so worried that they snapped up three-month Treasury bills with virtually no yield and they pushed gold to its biggest one-day gain in nearly 10 years. Stocks fell by nearly 5 percent in New York.

The stunning flight to safety, away from other kinds of debt as well as stocks, could cause serious damage to an already weakened economy by making it more expensive for businesses to finance their daily operations.

Some economists worry that a psychology of fear has gripped investors, not only in the United States but also in Europe and Asia. While investors’ decision to protect themselves may be perfectly rational, the crowd behavior could cause a downward spiral with broader ramifications.

“It’s like having a fire in a cinema,” said Hyun Song Shin, an economics professor at Princeton. “Everybody is rushing to the door. You are rushing to the door because everyone is rushing to the door. Clearly, as a collective action, it is a disaster.”

Faltering confidence could have an infectious effect in Asia, whose savings has essentially bankrolled America for decades. “Asia, perhaps more than other markets, is a bit more volatile, a bit more based on sentiment,” said Dan Parr, the head of Asia-Pacific for brandRapport, a consulting firm with an office in Hong Kong. “It doesn’t take much for the man on the street to become very, very concerned.” In early trading in Japan, the Nikkei index fell 3 percent.

Despite government efforts to reassure investors over the last 10 days by rescuing some giant institutions — Fannie Mae, Freddie Mac and American International Group — many investors remain worried that the financial system has been badly battered and that more firms may fail as Lehman Brothers did.

The Federal Reserve has greatly expanded its lending to banks and securities firms this year and is continuing to relax rules that govern financial companies in hopes of alleviating the credit squeeze. Central banks globally are also injecting more money into their economies and lowering reserve requirements for their own institutions out of concern that the problems in the American financial system will inflict further damage.

If the problems in the financial system persist, businesses will have less money to put to work, job cuts will spread and consumers, already fearful, will have less money to spend, knocking the economy down another notch. High borrowing costs will further weaken the housing market, which is still struggling. The Commerce Department reported Wednesday that housing starts fell to their lowest level since early 1991.

Flashes of fear were evident Wednesday as investors clamored for government debt. When investors bid up the price, the yield falls, and it sank on three-month Treasury bills to 0.061 percent, from 1.644 percent a week ago. The yield was the lowest in more than 50 years.

In the stock market, the Standard & Poor’s 500-stock index fell 4.71 percent, to 1,156.39, the lowest close in more than three years. Worries over financial investments hammered even the well-regarded Wall Street firms of Goldman Sachs, whose shares fell nearly 14 percent, to $114.50, and Morgan Stanley, whose shares dropped more than 24 percent, to $21.75. Now, both firms are reconsidering what their best strategies might be in such a fearful market.

In addition to shares of financial companies like Bank of America, those of other bellwethers like General Electric have also tumbled.

Responding to this pressure, the Securities and Exchange Commission proposed new rules on short selling, or betting on falling share prices, and even suggested that hedge funds and others might have to disclose short positions, a proposal that is likely to meet stiff resistance.

One key overnight lending rate was above 5 percent on Wednesday, more than double its level a week earlier. GMAC, the auto finance company owned in part by General Motors, had to pay interest of 5.25 percent on Wednesday for a form of short-term financing known as one-week commercial paper, up from 4 percent the previous day.

Businesses, stung by high interest rates, may be forced to trim expenses, an ominous turn in a slowing economy with unemployment rates on the rise.

“This is throwing sand in the gears of the economy,” said G. David MacEwen, chief investment officer for the bond department of American Century Investments. “The economy depends on credit to finance homes, automobiles, student loans, and inventories.”

Local governments and other enterprises will feel pressure, too. The city of Chicago and Lincoln Center in New York postponed debt offerings because they would have to pay such high interest rates to investors, said Daniel S. Solender, director of municipal bond management at Lord Abbett & Company.

Money market funds braced for possible fallout from the disclosure that one big fund’s net assets fell below $1 a share, because it had held securities issued by Lehman Brothers. It is so rare for money market funds to fall below that threshold that many investors consider them as safe as cash or a checking account.

Some mutual fund companies reported that customers were moving money from broader money market funds that have had higher yields to more conservative funds within the same company, Peter Rizzo, a senior director of Standard & Poor’s, said late Wednesday afternoon. The overall effect is to reduce the appetite for securities of companies with anything other than the most stellar reputations.

Governments around the world stepped up their efforts to ease the strain on the global financial system. The Bank of England extended a special bank lending program for three more months, while central banks in Japan and Australia injected more money into their banking systems. Russia injected money into its banks and lowered reserve requirements.

In New York, the Federal Reserve on Tuesday night said it would extend an $85 billion credit line to the insurer A.I.G. and receive the rights to a nearly 80 percent stake in the company. The deal came just after the government refused financial support to Lehman, leading it to file for bankruptcy on Monday.

The Treasury and Fed also said they would auction more Treasury bills. The Fed will use the securities to manage its balance sheet and inject more money into the financial system. Because the Fed has expanded its lending to banks and securities firm this year, some analysts had grown concerned that the central bank might run out of Treasury securities to conduct its operations. Mark Gertler, an economics professor at New York University, said the Fed was trying to balance two interests: protecting against a crisis but telling the market that it will not bail out every troubled institution. Despite the stress in the markets, he said, the Fed’s actions may have averted a worse outcome.

“Maybe this is being Pollyannaish, but they have been successful in signaling that the bailouts are no longer automatic, and thus far they have prevented a market meltdown,” Mr. Gertler said.

The dramatic events of the last year have called into question much of what policy makers, economists and investors once espoused about the financial system. As recently as the spring of 2007, many in Washington and New York continued to say housing prices could not fall across the board and that most of the bets made by Wall Street traders were inherently safe.

Now, there are signs that psychology is driving a reverse line of thinking. People are assuming that things will get worse and that any move by the Fed or the Treasury is a step down, not a step closer to improvement.

“There has been a tremendous amount of denial over the past two years, three years,” said Barry Ritholtz, chief executive of Fusion IQ, an investment firm, and author of The Big Picture blog. “The list of really, really bad decision making and poor analysis from Wall Street is legendary.”

The Treasury’s benchmark 10-year note rose 6/32, to 104 28/32, and the yield, which moves in the opposite direction from the price, fell to 3.41 percent from 3.44 percent late Tuesday. Following are the results of Wednesday’s auction of 35-day cash management bills:

Diana B. Henriques and Hilda Wang contributed reporting.

Diana B. Henriques and Hilda Wang contributed reporting.