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MARKET TAKES ANOTHER PLUNGE

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By NEIL IRWIN and DAVID CHO

The Washington Post

Published: September 18, 2008

WASHINGTON - The flow of money through critical parts of the financial system all but stopped Wednesday, prompting the stock market to plunge again as banks lost faith in one another and investors rushed to U.S. government securities to protect their savings.
Goldman Sachs and Morgan Stanley, the only major investment banks still standing amid the wreckage of Wall Street's old order, tottered.

In one of the most tumultuous days ever for financial markets, the Dow Jones industrial average fell 449 points, or 4 percent, and so much money fled into safe U.S. debt that buyers were at one point willing to accept interest rates for Treasury bills of only 0.2 percent, the lowest since World War II.

The financial toll continued to mount despite a series of escalating steps taken by the government in recent weeks. As one investment bank failed Sunday and another was taken over, the Federal Reserve loosened its lending to troubled institutions.

Then, in its most dramatic step yet, the government on Tuesday took over the enormous insurance company American International Group and extended it an $85 billion emergency loan. None of these measures succeeded in stopping the accelerating troubles.

"Investors are worried there is a lot more out there," said Robert MacIntosh, chief economist for Eaton Vance Management in Boston. "What other firms are going to collapse?"

The seizure in the credit markets made it difficult for corporate giants of American industry to raise money through the short-term debt they use to make their payroll and extend credit to customers.

Ordinary Americans by the millions invest in that short-term debt, called commercial paper, through money-market mutual fund accounts.

On Wednesday, those money-market mutual funds were trying to unload commercial paper on fears of further problems, making it hard for all but the best-rated companies to borrow the money they need. That, in turn, led banks to hoard cash, which sharply raised borrowing costs for ordinary Americans. At one point, the rate that banks charge each other for overnight loans reached 6.4 percent, about triple what it would be in normal times.

The panic in credit markets made for tough sledding for the two remaining independent investment banks, which fund themselves with short-term borrowing. Both companies' stocks experienced their steepest single-day drop ever: Goldman Sachs down 14 percent and Morgan Stanley down 24 percent.

Morgan Stanley CEO John Mack told employees that "there is no rational basis for the movements in our stock" and that "we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down," according to a staff memo.

Government leaders scrambled to consider their options. Officials at the Treasury Department and Federal Reserve called contacts in financial markets and counterparts around the world to weigh any further intervention. As of last night, neither agency had any public comment on the distress.

The Securities and Exchange Commission instituted new rules to combat the "naked short selling" of stocks, a way of betting on their declines without having borrowed actual shares first.

The ban could make it harder for hedge funds to make big bets against the shares of troubled companies. SEC Chairman Christopher Cox announced that he was asking the commission to urgently consider new rules requiring hedge funds and other large investors to disclose their short positions.

The Treasury Department, meantime, auctioned $40 billion in new debt to put the Federal Reserve in a stronger position to make future emergency loans, like those extended in the AIG takeover and the rescue of the failing investment bank Bear Stearns in March. The Treasury also established a procedure allowing it to auction off more debt if the Fed requires.

"They're recognizing that they may need more capacity in the days ahead, or at least they want to have that capability to intervene further," said Peter Hooper, chief economist at Deutsche Bank Securities and a former Fed economist.

Throughout the past year, the Fed has been creative at using its authority and nearly $900 billion balance sheet to try to ease the impact of the crisis.

The Fed can lend money to any individual, partnership or corporation under unusual and exigent circumstances. Even after a series of unconventional loans in recent months, the Fed had $479 billion of Treasury securities it could tap for future actions. But what further options the Fed has remains unclear.

Even as they tightened their lending, banks were evaluating what the future may hold and looking for pairings.

The turbulence was widespread through markets in the United States and abroad. Crisis deepened abroad, too, especially in Russia, where the government halted trading in stocks for the second straight day because of steep declines.

Stocks fell in almost every nation with an exchange.

Some of the most severe - and surprising - damage to the financial system involved money-market funds, one of the most widely held types of investment in America and a key component in the way corporations and investment banks finance their businesses. Managers of those funds, which control $3.6 trillion, fled for safe havens, which aggravated a vicious cycle in the credit markets.

Many of these funds, long seen as one of the safest places for ordinary investors and businesses to park their money, have decided to play it safe and put their holdings into Treasury bonds, which are fully backed by the U.S. government. Several funds have even incurred losses, though in most cases they have stepped forward to cover them.

The price of gold, which rises in times of panic, spiked as much as $90.40 an ounce.

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