-- Lehman Bros. Merrill Lynch. Fannie Mae. Freddie Mac. Countrywide Financial. Bear Stearns. In staggering succession, some of Wall Street's oldest and biggest firms have been seized, failed outright or merged into other companies.
"It's the worst news out of Wall Street since I've been alive," says Steve Romick, manager of FPA Crescent fund.
The credit crunch, which began in the real estate market, has emerged as a full-blown financial crisis threatening the global credit markets. Thanks partly to nimble emergency moves by the U.S. government, the financial system has avoided a full-scale collapse. There is widespread concern, however, that other financial institutions could be brought down by the sliding home mortgage market.
In the short term, it will be harder for people with shaky credit to get loans, particularly mortgages. And if you're investing in stocks for retirement, your savings have shrunk by 20% or more in the past 12 months. For most others — even those invested in brokerage accounts at Lehman leh or Merrill mer— the developments are likely to have little immediate effect because of government safeguards that protect individual investors with up to $500,000 in their accounts.
On Wall Street, though, the hurt runs deep and broad. Two Wall Street icons are about to vanish as independent companies. Lehman Bros., which began 158 years ago as Alabama cotton traders, filed for bankruptcy protection. And Merrill Lynch, whose bull mascot has been Wall Street's iconic symbol of optimism since 1970, agreed to be absorbed by Bank of America.
"It took my breath away," says Jim Dunigan of PNC Wealth Management. "I don't think anyone would have come up with that scenario."
The stock market, still reeling from the government takeover of mortgage giants Fannie Mae fnm and Freddie Mac fre, plunged Monday.
The Dow Jones industrial average sank 504 points, or 4.4%, to 10,918 in the biggest point drop since Sept. 17, 2001, the day stock trading resumed after the Sept. 11 attacks. Monday's sell-off wiped out $700 billion in shareholder wealth.
As bloody as Monday's market trading was, the carnage was less than some had expected. "It wasn't pretty, but it wasn't a catastrophe," says Bill Gross, manager at the Pimco mutual funds.
Even so, the danger isn't over. Analysts say too many companies have borrowed too much to buy high-risk assets — mainly securities backed by subprime mortgages, which are loans made to borrowers with poor credit.
Now, companies that own those securities must write off their losses and raise fresh cash. That means fewer consumer loans and stricter loan standards, says Hugh Johnson of Johnson Illington Advisors.
More cautious lending
The unfolding financial crisis means that banks — those that do not fail — likely will become much more cautious about how much they lend, and to whom, than they were from 2004 to 2007. "It's back to basics," Johnson says.
The stock market was spared an even steeper fall Monday because the government had moved to make sure Lehman's collapse didn't spark the immediate failures of dozens of other financial institutions.
It was a vital step. Lehman is an investment bank. Unlike a traditional bank, which makes loans, an investment bank arranges financing for commercial banks, companies, cities and states. Should a city, say, need to issue bonds for a new bridge, an investment bank will arrange the terms of the financing and sell the bonds to interested investors.
But Lehman also arranged many other types of financing, including debt backed by subprime mortgages and complex financial arrangements called derivatives. On a given day, many of those notes come due or are renewed. The government assured those who might have trouble with their Lehman trades that they could receive short-term loans until matters can be sorted out.
To make sure that companies weren't caught short, the Federal Reserve made it easier for troubled institutions to raise cash. Meanwhile, a group of 10 major banks cobbled together a $70 billion emergency loan pool.
The crisis could spread. American International Group AIG, an insurance giant, is scrambling to raise cash. Shares of Washington Mutual, the nation's largest savings and loan, have plunged more than 90% during the past 12 months. Both have been damaged by heavy subprime mortgage holdings.
Before they can resume normal operations, the companies must sell off their bad holdings and raise more money. "Until some entity with a checkbook steps up to buy those assets, instead of the government financing them, then we have a problem," Pimco's Gross says.
That will be difficult. For one thing, AIG and Washington Mutual are only the most visible companies trying to raise capital and sell problem investments. Other large holders, such as hedge funds and sovereign wealth funds, are scrambling to unload such securities, too.
But few investors want to buy subprime-mortgage-backed securities. And those who are willing to do so will buy them for just pennies on the dollar. So not only are those troubled securities nearly impossible to sell, they're worth far less than their holders would like.
"They're marked to the low-ball bid," says Ron Muhlenkamp, portfolio manager of the Muhlenkamp fund. So even if the institutions don't sell their holdings, the assets they count as capital have been marked down drastically. That, in turn, reduces the institutions' ability to operate.
Financial institutions seldom suffer alone. When banks take losses, or fail entirely, fewer loans are available for homes and businesses. A $1 billion loss at a major bank could mean that as much as $10 billion is no longer available to lend, says FPA's Romick. (Bank loans are often deposited in other banks, giving those banks the ability to borrow more.)
Fewer loans mean companies will have less money to borrow to expand. That could spell further weakness in the economy.
For financial services companies, even a best-case scenario could mean huge stock losses. When a company raises fresh capital, it dilutes the value of existing shares. And many financial services companies need capital.
Politicians and market participants are calling for reforms. Some argue that accounting rules are forcing banks to mark down their holdings too sharply.
"Real estate in a lot of areas is down 20% to 25%, but banks are being forced to mark down their portfolios 60% to 70%," says former FDIC chairman William Isaac. Those sharp markdowns severely limit the amounts banks can lend, making an already sluggish economy even weaker.
"Someone has to stop this nonsense," Isaac says.
Others worry that offering too much aid to failing institutions encourages reckless behavior, a type of risk called "moral hazard." That's one reason the government didn't bail out Lehman Bros., as it did Bear Stearns. Federal officials decided that giving government backing to two major investment banks would be worse, in the long run, than doing so for just one.
"Moral hazard is something I don't take lightly," Treasury Secretary Henry Paulson said Monday.
But Jon Faust, director of the Center for Financial Economics at Johns Hopkins University in Baltimore, says people shouldn't read Lehman's trip to bankruptcy protection as a sign that the Fed won't ever step in again to prevent an investment bank's failure.
So far, at least, investors aren't panicking. Calls to the Vanguard Group, the big mutual fund company, "surged at the beginning of the trading day and subsequently subsided," says spokesman John Woerth. There was no increase in stock fund redemptions, he says.
"We're stressing that the fundamental benefit of a mutual fund is that you're broadly diversified," Woerth says.
Vanguard Total Stock Market Index, Vanguard's largest fund, has only 0.02% of its assets in Lehman stock and 0.19% of its assets in Merrill Lynch, Woerth says.
T. Rowe Price also saw a jump in calls from investors Monday morning, but by afternoon, "It had leveled off a bit," says spokeswoman Heather McDonold.
"Investors are more inquisitive than jittery," she says. T. Rowe doesn't disclose information about fund redemptions.
If you're an investor, taking a few steps can help you weather the storm. Try to pay off any high-interest loans. Repaying a credit card with a 19% interest rate is equivalent to earning 19% on an investment.
If you don't have an emergency fund, start one. Ideally, you should have enough in the bank to pay at least three months' worth of bills. If you're laid off, you'll need your emergency fund to tide you over while you're looking for a new job.
FPA's Romick remains cautious about investing in stocks in general and financial stocks in particular. The Standard & Poor's 500-stock index is down about 20% from its October peak (assuming dividends were reinvested), Romick says.
These are no ordinary times, he says. When banks and investment banks fail because they borrowed too much to buy bad assets, "It doesn't end with the market being down just 20%."
A silver lining?
Optimists point out that the recent failures can be a positive because the financial system finally will measure the size of its problems and work to fix them, says Jonathan Merriman, CEO of investment bank Merriman Curhan Ford.
"You're talking about the guys with the most exposure to the toxic paper," he says. "You're coming to the end of the list."
The fact that Bank of America is willing to buy Merrill Lynch in what seems to be the depth of the turmoil shows that at least one bank sees a recovery coming, says Keith Stock, CEO of investment management firm First Financial Investors.
Portfolio manager Muhlenkamp is anxious about the economy and the market but is fairly sanguine. "Have we been there before? Yes," Muhlenkamp says. "Is the flavor different? Yes. Will we survive? Yes."