Failed bailout vote hits Wall Street like a hurricane

NEW YORK -- The "nay" vote heard around the world wiped out $1.2 trillion in stock market wealth Monday, the first one-day trillion-dollar loss in Wall Street history.

Warnings of a stock meltdown turned into a scary self-fulfilling prophecy after a divided House voted down a financial rescue plan that was specifically created to avoid the kind of panic selling that engulfed markets around the globe.

The financial fallout was of the Armageddon proportions that some predicted if the $700 billion bill — which was promoted by the Bush administration as the best way to boost investor confidence and unclog frozen credit markets that have created a daily bank death watch on Main Street — failed to pass.

"It was the equivalent of a Category 5 hurricane," says Scott Black, president at Delphi Management.

The broad U.S. stock market, as measured by the Standard & Poor's 500-stock index, suffered an 8.8% free fall — its biggest percentage decline since the 1987 stock market crash. Only one stock in the index — Campbell Soup — finished higher.

The 30 stocks in the Dow Jones industrial average suffered their worst one-day point drop ever, plunging 777.68 points, or 7%, to 10,365.45.

The massive losses "made the hair on the back of your neck stand up," says hedge fund manager Patrick Adams of Choice Investment Management.

On the New York Stock Exchange, more than 3,000 stocks finished down, and fewer than 200 stocks closed higher.

Many Wall Street pros blamed lawmakers for the historic downdraft.

"Congress snatched defeat from the jaws of victory," says Michael Farr, president of money management firm Farr Miller & Washington. "And stockholders voted with their feet."

Gary Kaltbaum, president of Kaltbaum & Associates, blames the sell-off on "the scare tactics" used by lawmakers. "They set this drop up by scaring us. They said if the vote was not yes, the market would get crushed." And it was.

Investors scurried to the sidelines and to the safety of cash and U.S. government bonds because they fear that the banking system is at greater risk of seizing up and causing untold damage to an economy already struggling under the weight of the worst housing bust and credit crisis since the Great Depression, says Jack Ablin, chief investment officer at Harris Private Bank.

The centerpiece of the plan, hatched by Treasury Secretary Henry Paulson, was for the government to buy toxic mortgage-related assets from banks so that they could begin lending again. But that plan is on hold, causing investors to fret about worst-case scenarios. "It is a race against time," says Ablin.

The market's big fear, says Ablin, is that the credit markets will freeze up so severely that ordinary Americans, as well as businesses in sectors outside the troubled financial sector, will not be able to get loans. And if credit, the gas that powers the economy, is not available or in plentiful supply, the economy will suffer a significant slowdown.

U.S. investors are also starting to become concerned that the credit crunch will infect the entire world, causing a global economic slowdown.

"The situation is not beyond repair," says Doug Peta, market strategist at J&W Seligman. "But it looks like Congress will have to go back to the drawing board, which will delay passage of the bill. And every day of delay is another day of pressure on banks."

Individual investors are starting to wonder if time is running out.

What began as a fairly normal day at investment firm T. Rowe Price got more complicated after the bailout defeat in the afternoon. "We saw a spike in call volumes," says spokesman Steve Norwitz. Many callers "were expressing concern about the market and asking for advice, such as what they should do now and how this might (affect) their portfolio," he says. The firm doesn't disclose numbers for mutual fund redemptions, but there's "no doubt we saw a pickup in selling, or people exchanging out of equity funds," says Norwitz, who added that there was also some buying.

Clients were ringing up Farr, as well. "I've had clients call who wanted to sell everything," he says. But some were seeking bargains. "One client called at 3:30 p.m. and wanted to buy $500,000 worth of his favorite 10 stocks," he says.

Some Wall Street pros say the massive sell-off had all the earmarks of a selling climax. For example, a closely followed "fear index," known as the VIX, closed at 46.72, its highest ever, says Bespoke Investment Group. Only four other times since 1990 has the VIX closed above 40, and the S&P 500 was up 8.7%, on average, a month later and 11.3% higher three months later, Bespoke says.

The rising fear resulted in big losses in the technology-dominated Nasdaq, which tumbled 9.1%, closing below 2000 for the first time since May 2005. Bank stocks also took it on the chin. An exchange traded fund that tracks banks fell 14.4%. The banking sector was rocked by Citigroup's takeover of troubled North Carolina bank Wachovia. Last week, Washington Mutual collapsed and was bought by JPMorgan Chase in the biggest bank failure in history.

The market nose-dived even though the Securities and Exchange Commission's 10-day emergency ban on short sales of stock for more than 1,000 financial firms remained in place. Short sellers, who profit when stock prices fall, have been blamed for putting investment bank Lehman Bros. out of business. The ban, which took effect on Sept. 18, is set to expire late Thursday night. But the SEC can extend it for 10 trading days.

"The selling was pretty climactic," says Price Headley, chief analyst at BigTrends.com. "This is about as scared as people can get, and often occurs at major crisis points." The market is like a coiled spring right now, he says, and could rebound sharply if the government comes back and passes some kind of revised bailout plan.

Dan Seiver, a finance professor at San Diego State University, says the market is in a no-win situation. If the government passes a bailout bill, it will be expensive, and there will be great uncertainty as to whether it will work. If no bailout arrives, the level of uncertainty as to how bad things will get and how many banks will fail will nag at the market.

One thing the government must stop is the perception that a bank a day could fail. "At some point, Wall Street will lose all confidence when you take these banks out one at a time," says Seiver. "It's like staring into an abyss. The abyss has a bottom, but you don't know how far down it is."

There is a general consensus that a bailout of some sort is needed to avert a very bad outcome.

"If the no vote is categorically a no, then they are playing with fire," says Robert Barbera, chief economist at ITG. "I'm not saying I know for certain that the financial system can survive with this help. But what I am saying is I would not run that experiment even if it was politically advantageous."

The stakes are high. Barbera says "confidence with a capital C" is presumed to be in place only when investors believe the system as they know it is there when they wake up in the morning.

He notes that the government's prior attempts at stabilizing the market based on a situation-by-situation basis have failed to stabilize global markets. And the government risks a poor outcome if it doesn't come up with a comprehensive solution.

Black of Delphi Management agrees. "This is severe. We have never seen anything like it in our lifetime. There is no perfect solution. But there has to be a sense of urgency, because we risk a complete capitulation of our global banking system."

Signs of U.S.-style banking woes spreading around the globe intensified Monday. European governments announced a handful of bank bailouts of their own. And stock prices fell sharply in Europe, Asia and South America. London shares fell 5.3%, Germany dropped 4.2%, and France fell 5%. Latin American stocks fell more sharply because they were still trading when the failed bailout vote news broke. Brazil's market fell 9.4%. Early Tuesday in Tokyo, stocks fell 5% in the first half-hour of trading.

Investors again rushed into safe investments. The price of gold topped $900 an ounce in after-hours trading. And the yield on the three-month Treasury bill fell to 0.14% from 0.87% Friday, a clear sign that investors were looking to preserve capital.

The selling pressure was so intense that it caused problems at the New York Stock Exchange. The stock drop accelerated sharply shortly before the market closed, causing a 10-minute delay after the 4 p.m. closing before the record decline became official. "There were huge sell imbalances at the end," said NYSE spokesman Scott Peterson, adding it was difficult to determine immediately if the late drop resulted from hedge funds or other major players using electronic trades to sell large volumes of shares.

The historic losses shook up many investors, including one who says he rarely gets spooked. "Am I scared? A little, and I pride myself on not being shaken by the market," says Robb Muse, 39, a financial services manager from Pennsylvania. Asked if a bailout deal is needed, he replied: "YES!!!!!!!"