Stocks plunge after crisis in investment firms

US hastens to ease fears, keep credit flowing; Another stimulus package and rate cut may be in offing

Uncertainty reigned yesterday outside the world headquarters of Lehman Brothers Holdings Inc. in New York. (Shannon Stapleton/Reuters)

Stocks suffered their worst losses in seven years as the failure of investment firm Lehman Brothers Holdings Inc. and the sudden sale of Merrill Lynch & Co. stoked investor fears of even deeper problems in the nation's financial system.

The Dow Jones industrial average plunged more than 500 points, the biggest one-day drop since the Sept. 11 terrorist attacks in 2001. Investors also nervously watched the fate of the world's largest insurance group, American International Group Inc., which is scrambling to line up as much as $75 billion to shore up its weakened finances. The Dow ended at 10,917.51, the lowest close in more than two years.

Meanwhile, policy makers from President Bush to New York Governor David Paterson moved yesterday to prevent further panic that could cause even greater damage to the financial system and the US economy.

The Federal Reserve has made additional money available to banks to keep the flow of credit going in markets, while New York regulators allowed AIG to use $20 billion in assets from its insurance subsidiaries to bolster the parent firm's balance sheet. The insurance firm last night was also trying to arrange additional capital through loans from Goldman Sachs Group Inc., and JPMorgan Chase & Co., after US officials rebuffed its request for federal help, according to news accounts.

Late last night, the major credit-rating agencies - Standard & Poor's, Moody's Investors Services, and Fitch Ratings - downgraded AIG's ratings at least two notches. While the new ratings are all still considered investment grade, the moves add to the pressure on AIG.

"Adjustments in financial markets can be painful," Bush said. "But in the long run I am confident that our capital markets are flexible and resilient and can deal with these adjustments."

The fallout has reached across the globe. The Asian markets plummeted today, with Japan's benchmark Nikkei 225 index down 5.3 percent to 11,560.66 in mid-afternoon trading and Hong Kong's blue-chip Hang Seng Index shedding 5.7 percent.

The market upheaval could also reshape the financial services industry in Greater Boston, raising questions about the future of Bank of America's money management operations in Boston. Bank of America is buying Merrill Lynch, but bank officials said they have not determined how they will combine operations.

Meanwhile, the financial crisis could mean the loss of hundreds of financial services jobs, not just at Lehman's offices, but at other investment firms in Boston. Losses in the stock market and declining values of other assets reduce the profits of the many mutual fund companies and private equity and venture capital firms that are located here.

"We've been dealing with this situation for the better part of 18 months," said Kevin M. Cronin, chief of investments at Putnam Investments in Boston. "It's just gone on much longer than people had anticipated. It has broadened in its scope and its reach and its duration as well."

In Washington, congressional Democrats said they would push to pass a new, $50 billion stimulus package to aid the US economy in the wake of the financial turmoil. Some analysts predict the Fed may again also cut interest rates - perhaps as early as today, when policy makers meet. That could boost the economy by making it cheaper for businesses and consumers to borrow.

The Fed, concerned about rising inflation this year, has held its key interest rate steady since spring, at a historically low 2 percent. But oil prices, which have largely been blamed for the jump in inflation, are suddenly dropping, and that could give the Fed the room to lower rates again.

Crude plunged about $9 barrel yesterday and early today to $91.80. The fall was the biggest two-day drop in almost four years.

"Inflation is not a problem," said Nariman Behravesh, chief economist at Global Insight. "The Fed is going to have to cut, if not Tuesday, then soon after."

Meanwhile, another positive for the economy is the recent drop in mortgage rates, which fell more than a half percentage point after the US government took over home loan funders Fannie Mae and Freddie Mac last week. Rates again nudged downward yesterday, as investors piled into the safety of bonds such as 10-year Treasury notes, to which many mortgage rates are tied.

Still, many analysts say lower interest rates won't have much impact because lenders, worried about ending up like Lehman, will cut back on making loans to preserve capital they may need to survive the turmoil. In Boston, real estate professionals said that will worsen a credit crunch that has already forced developers to delay major projects, such as the redevelopment of Downtown Crossing and Columbus Center.

"The reality is the headwinds have never been greater for financing large projects," said George Fantini, chairman of mortgage banking firm Fantini & Gorga. "There is no nice way to state how difficult that situation is."

Lehman and Merrill Lynch are the latest to succumb to the nation's housing crisis, which began with risky loans known as subprime mortgages and spread in a vicious downward cycle to the broader credit markets. Both Lehman and Merrill Lynch had large holdings of securities backed by mortgages, which have fallen sharply in value as home prices have declined and foreclosures soared. Both have reported billions of dollars in losses over the past year.

For these companies, the decline in the housing market made it difficult to recover. As home values slipped, so did the value of their assets, requiring them to raise more money to offset the losses, which in turn became even harder as housing markets deteriorated without an end in sight. Merrill acted before it was too late, finding a buyer in Bank of America, which has the financial underpinnings to weather the downturn.

Lehman, which was long ranked among Wall Street's more troubled firms, was too far gone. Federal officials over the weekend tried to engineer a sale, such as the one that avoided the collapse of investment firm Bear Stearns Cos. in March. But unlike the Bear Stearns deal, in which the Federal Reserve guaranteed up to $30 billion of Bear Stearns' troubled assets to entice the buyer, JPMorgan Chase, policy makers refused to put taxpayer money at risk to provide a similar guarantee for Lehman.

Two potential suitors, Bank of America and Barclays PLC, the British financial services company, walked away, according to published reports.

Under criticism already for the Bear Stearns bailout and the takeover of mortgage giants Fannie Mae and Freddie Mac, policy makers decided they could let Lehman fail without catastrophic results, analysts said.

Conditions had changed since that sudden Bear Stearns collapse, which prompted a Depression-era style run on funds by investors, and a near-halt of the global financial system. Since then, the Fed has opened its lending window to securities dealers and other investment firms to provide liquidity, or ready cash, to keep the system operating.

With the Fed making plenty of money available, it became unlikely that Lehman would bring down the financial system, analysts said. "The only reason you do is you think the turmoil is going to be so great, the market can't cope," said Jaret Seiberg, policy analyst with the Stanford Group in Washington. "Everyone knows the Fed is there to provide emergency liquidity, so it's not complete chaos."

While Lehman's collapse will add to unemployment rolls - the nation's jobless rate has soared above 6 percent in recent months as hundreds of thousands of employees were laid off - some economists found a silver lining: The failure may signal that the financial industry is finally working through its crisis of devalued assets and problem loans.

"The Lehman fallout should be fairly contained," said Stuart Hoffman, chief economist at PNC Financial Services Group in Pittsburgh. "The reality is the economy is already in recession, and Lehman is more a symptom than a cause."

Robert Gavin can be reached at rgavin@globe.com. Globe staffers Beth Healy, Ross Kerber, Jenifer McKim and Casey Ross contributed to this story. Material from Globe wire services was also used.