The Nightmare on Wall Street: Inside the Trades, Tumbles and Turmoil

"Terrible" only begins to describe Monday's disaster on Wall Street, as one bank filed for bankruptcy, another was bought for a song and an insurance giant faced a struggle to stay solvent.

The Dow Jones had its biggest single-point drop for 2008, losing 504.48 points (-4.42 percent) to close at 10,917.51. It was the sixth-biggest point drop in the history of the index, the biggest point drop since the first day of trading after Sept. 11 and the biggest percentage drop since July 19, 2002. The Dow closed at its lowest point since July 21, 2006.

The Dow is down 17.7 percent so far this year and, from its peak in October 2007, the index has dropped nearly 23 percent.

The S&P 500 had its lowest close for the year, losing 59 points (-4.71 percent) to close at 1,192.70, while the NASDAQ lost 81.36 points (-3.60 percent) to close at 2,179.91.

That said, considering the historic proportions the weekend's news, it could have been a lot worse.

To recap, Lehman Brothers filed for bankruptcy, Merrill Lynch was sold to Bank of America, and the world's largest insurance company, American International Group (AIG), is desperately trying to stave off insolvency.

Today's drop in the market came after the federal government made it clear this weekend that it was getting out of the business of providing taxpayer dollars to shore up troubled businesses.

After forcing a sale of Bear Stearns in March and taking on $29 billion in loan guarantees, and then stepping in to rescue Freddie Mac and Fannie Mae only last weekend, the government indicated, by not stepping in to provide funds for Lehman, that enough is enough.

Treasury Secretary Henry Paulson told reporters Monday, "I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers."

And President Bush said, "In the short run, adjustments in the financial markets can be painful, both for the people concerned about their investments and for the employees of the affected firms. In the long run I'm confident that our capital markets are flexible and resilient and can deal with these adjustments."

The short term, however, is looking ugly. Financial stocks at the heart of the storm saw big selloffs, with not just AIG and Lehman hitting their lowest stock prices for the year, but even sterling Goldman Sachs falling to an annual low.

What to Look for Tomorrow

After one day of trading, the selloff we saw today could continue through the week.

Asian markets, which were closed today, will open tomorrow and show their reactions to today's selloff. Big losses there could result in further losses in the United States.

The Federal Reserve meets this week to review interest rates. After the past weekend, it's possible that the central bank will lower rates to try to head off deeper losses.

Paulson is due to speak at the Brookings Institution about the housing market.

Goldman Sachs, one of the few giant investment banks still standing, reports earnings before the markets open.

August inflation figures will also be released.

Lehman Brothers

What Happened Today

The 158-year-old firm filed a Chapter 11 petition with U.S. Bankruptcy Court in Manhattan today.

Lehman employs about 25,000 people and lists more than $613 billion of debt, according to Bloomberg.

Lehman has survived the railroad bankruptcies of the 1800s, the Great Depression and the collapse of Long Term Capital Management a decade ago.

Only Lehman Brothers Holdings Inc. filed bankruptcy, not its brokerage or money-management subsidiaries. So those subsidiaries—most notably broker-dealer Lehman Brothers Inc., the firm most of us think of as Lehman Brothers—continue to operate outside of bankruptcy, though obviously under financial stress.

The bankruptcy filing blocks creditors from suing or otherwise trying on their own to recover money from the holding company.

The filing came under Chapter 11 of the Bankruptcy Code, meaning the firm can try to reorganize rather than just liquidate its assets.

Analysts said the move was designed to show the financial markets that Lehman management is dealing with its problems aggressively and to minimize risk.

Who's Affected

The bondholders, stockholders and other creditors of the holding company will have to line up to see how much of their investments they can recover. Bondholders, especially if their debt is backed by assets, may get something substantial. Stockholders will probably be wiped out.

Creditors and especially customers of Lehman's brokerage and various asset-management firms are not directly affected by the bankruptcy, though it obviously signals big trouble and may lower the value of any Lehman-backed securities, prompt customers to flee and damage the firms' ability to attract capital.

Thousands of employees and others who depend on Lehman for a living will be out of work, experts say.

What's Next

There are essentially three scenarios, the most likely being that Lehman Brothers Inc. and the other subsidiaries will try to sell their assets. The most valuable of those assets are probably the firms' relationships with their customers and investors, and since those relationships are already deteriorating, the sooner the sales occur -- and they are expected to occur by the end of the week -- the better.

Already being mentioned as possible buyers for the investment-management subsidiary, according to the Wall Street Journal: private equity firms Bain Capital, Hellman & Friedman and Clayton Dubilier & Rice. Any proceeds left after paying the subsidiaries' liabilities would become part of the holding company's bankruptcy estate.

A less likely scenario: the holding company sells its stock in the subsidiaries. That would require buyers to assume the liabilities as well as the assets of the subsidiaries, making buyers harder to find.

The least likely scenario: Lehman Brothers Inc. declares bankruptcy. Federal law would require it to file under Chapter 7 of the Bankruptcy Code, meaning it would have to liquidate and go out of business. Its stock would probably be worthless, so this would be the worst option for the holding company, but holders of brokerage accounts and other customers would be protected, because bankruptcy law gives them first dibs on the firm's assets.

AIG

What Happened Today

The Federal Reserve has reportedly asked investment banks JPMorgan Chase and Goldman Sachs to put together a $70 billion loan for AIG, according to the New York Times.

New York Gov. David Paterson announced today that AIG could borrow $20 billion from its own subsidiaries to cover its operating costs. Although Paterson has relaxed insurance regulations for AIG, he stressed that AIG was only borrowing from itself, not from New York or federal taxpayers.

"AIG policyholders are safe… this is not a government bailout … we are helping the company use its own assets to solve its problems," a spokesman for the New York Insurance Commission told ABC News today.

On the other hand, "allowing AIG to borrow from subsidiaries could weaken those subsidiaries," according to corporate law professor John Coffee.

AIG shares tumbled about 60 percent today amid fears that credit ratings agencies will downgrade AIG's debt. If credit ratings drop, AIG will find it harder to borrow money and make trades for its clients. AIG is also in danger from "short sellers" who are betting on further price declines of the stock.

The Federal Reserve is reportedly considering giving AIG a lifeline that could include a $20 million bridge loan. The Fed refused to extend this kind of loan to Lehman Brothers, signaling that AIG's financial health could pose serious threats to Wall Street.

What's Next

There is nothing to protect AIG shareholders from price declines.

AIG could be placed in receivership or conservorship, which means the New York state government would take control of it. The company would likely be administered by the N.Y. insurance commissioner (a member of the governor's Cabinet) who would appoint a receiver to run the company. The receiver could reorganize it, sell it, break it up or wind it down.

Insurance companies are generally not eligible for Chapter 11 bankruptcy protection, but non-insurance parts of the company might be (depending on how AIG is structured).

As previously discussed, the Fed could loan AIG money to keep it solvent. If that money isn't paid back, the federal taxpayer could be left holding the bag.

Finally, AIG could sell assets and/or subsidiaries.

Who's Affected?

Shareholders are the most at risk under any insolvency scheme. They are the last to get paid. They may be able to file lawsuits, but that assumes there would be money left over to recover. AIG's 100,000 employees risk losing their jobs and any equity they have in the company. For now, AIG policyholders appear to be safe. New York taxpayers may have to pick up some of the costs of running AIG if it falls into receivorship. Federal taxpayers could be on the hook if the Fed provides lending that isn't paid back. Insurance market as a whole could suffer. Insurance could become more costly and harder to come by.

What Is AIG.?

American International Group (AIG) is one of the world's largest insurance companies. It controls a trillion dollars in assets, employs over 100,000 people and has 74 million customers, according to the N.Y. Insurance Commission, the organization that regulates it.

AIG is a leading provider of property/casualty, life and specialty insurance to commercial, institutional and individual customers.

AIG is publicly traded on the New York Stock Exchange.

AIG has become one of the biggest underwriters of debt securities, including products that insure against losses in the mortgage industry.

Who Said What Today

Sec. Henry Paulson

Paulson began the White House briefing with calming words reiterating the president's belief in long-term economic resilience. "The American people can remain confident in the soundness and the resilience of our financial system," Paulson said, commending the SEC and Fed for their work over the weekend. However, a few lines during the Q-and-A period weren't as convincing.

When asked about more federal rescues, Paulson responded, "Don't read it as no more; read it as that, you know, it's important, I think, for us to maintain the stability and orderliness of our financial system. Moral hazard is something I don't take lightly."

"In terms of where we are in terms of working through this, I think we've got to go back to the housing correction, and where are we in the housing correction. And I believe that there is a reasonable chance that the biggest part of that housing correction can be behind us in a number of months," he said. "I'm not saying two or three months, but in months, as opposed to -- as opposed to years."

"I don't look at any one day, any one indicator, any one week," Paulson said. "There are going to be some real rough spots along the road, but I believe we're making progress. And when I look at the way the markets are performing today, I think it's a testament to the way the financial industry has come together. Because they're dealing with an extraordinary set of circumstances and they're dealing in a way we should all be proud of."

President Bush

President Bush addressed the financial markets before his meeting with the president of Ghana but didn't give details on what the future holds for Lehman, AIG and others. He admitted, "in the short run, adjustments in the financial markets can be painful" but tried to calm the news today saying in the long run he is confident the markets are "flexible and resilient."

"I know Americans are concerned about the adjustments that are taking place in our financial markets," Bush said in the Rose Garden. "At the White House and throughout my administration we're focused on them, and we're working to reduce disruptions and minimize the impact of these financial market developments on the broader economy."

"As policymakers we're focused on the health of the financial system as a whole," Bush added. "In the short run, adjustments in the financial markets can be painful, both for the people concerned about their investments and for the employees of the affected firms. In the long run I'm confident that our capital markets are flexible and resilient and can deal with these adjustments."

The president expressed gratitude toward Treasury, SEC, and the Fed saying, "I appreciate the work that the Treasury Department and the Federal Reserve and the Securities Exchange Commission and major final institutions here and around the world are doing to promote stability in the financial systems," according to the Associated Press.

Sen. John McCain

"Today we are seeing tremendous upheaval on Wall Street," the senator said, according to ABC's Ron Claiborne. "The American economy is in crisis. Unemployment is on the rise and our financial markets are in turmoil. People are concerned about our economic future. But let me say something: this economic crisis is not the fault of the American people. Our workers are the most innovative, the hardest working, the best skilled, most productive, most competitive in the world. My opponents may disagree, but those fundamentals of America are strong. No one can match an American worker. Our workers sell more goods to more markets than any other on earth. Our workers have always been the strength of our economy, and they remain the strength of our economy today.

"From Washington to Wall Street, the top of our economy is broken. We have seen self interest, greed, irresponsibility and corruption undermine the hard work of the American people.

"But those fundamentals are being threatened today because of greed and corruption that some indulged in on Wall Street ... Those fundamentals are threatened because some on Wall Street treated Wall Street like a casino."

Barack Obama

"Today of all days, John McCain's stubborn insistence that the 'fundamentals of the economy are strong' shows that he is disturbingly out of touch with what's going in the lives of ordinary Americans," said Obama campaign spokesman Bill Burton. "Even as his own ads try to convince him that the economy is in crisis, apparently his 26 years in Washington have left him incapable of understanding that the policies he supports have created an historic economic crisis."

In a prepared statement, Obama called the latest of Wall Street's disasters the "most serious financial crisis since the Great Depression" and blamed it on Republican policies.

"I certainly don't fault Senator McCain for these problems," Obama said, "but I do fault the economic philosophy he subscribes to."

"The challenges facing our financial system today are more evidence that too many folks in Washington and on Wall Street weren't minding the store," Obama said in his statement. He pointed to "eight years of policies that have shredded consumer protections, loosened oversight and regulation, and encouraged outsized bonuses to CEOs."

Sarah Palin

"This is an issue of real concern," Palin told thousands gathered in a rodeo ring in Golden, Colo. But, she said, "I'm glad to see the Federal Reserve has said no to using taxpayer money for a bailout."

"We're going to reform the way Wall Street does business and stop the golden parachutes for CEOs who betray the public trust," she said.