Each new day seems to bring a fresh milestone in the markets, and Wednesday was no exception. The Dow Jones industrial average staged its biggest plunge in percentage terms since the crash of 1987. It ended down 733 points to 8,577, as investors worried about the depth of a coming recession and hedge funds sold to cover margin calls.
Japan's key stock index plunged more than 10 percent in early trading Thursday, following Wednesday's dive on Wall Street.
The sell-off started from the moment the opening bell rang, as investors became increasingly convinced that a recession was not only coming but was inevitable. The Commerce Department added fuel to the fire when it released its September retail sales figures: They were down 1.2 percent — the biggest decline in three years.
"It was a dismal report," Cary Leahey, senior economist at Decision Economics, told Michele Norris on All Things Considered on Wednesday. He said the Commerce Department report may be showing the early stirrings of a consumer-led recession.
"I think the economy went into recession earlier this year, and it intensified in September before the market melted down," he said. "I think we're going to have a long and, unfortunately, deep downturn. If it stretches into next year, we're talking about the worst recession since the 1930s."
Hours after the Commerce Department report rattled investors, the Federal Reserve released its snapshot of the economy across the Fed's 12 regional districts. The so-called Beige Book (which is named after the color of its cover) confirmed what the Commerce Department report said. It showed that back in September — before the markets started to collapse in a big way — consumers were already cutting back on their spending. Business owners told the Fed they were downright pessimistic about the future.
All that gloom naturally was felt on Wall Street. The Dow's declines over the past two days managed to erase most of Monday's more than 900-point gain. Analysts said part of the sell-off was motivated by the economic doomcasting; the other part was hedge funds dumping shares to make margin calls. Market watchers said they expect more hedge fund selling in the days ahead.
Federal Reserve Chairman Ben Bernanke, in a speech before the Economic Club of New York on Wednesday, offered a clear-eyed, if not a little downbeat, assessment of what lies ahead. Most economists agree the economy will shrink in the last quarter of 2008 and continue to contract in the first quarter of next year. Bernanke seems to be in that camp. He said that it was likely economic activity will "fall short of potential for a time."
Credit Markets
For some time now, investors have been watching liquidity in the credit markets. The thinking has been that if banks start lending to each other again, the global financial system would get back on track. Bernanke said the turmoil in credit markets poses a "significant threat" to an already slowing U.S. economy and, as he saw it, it would take some time for credit flows to return to normal.
Credit markets are improving only on the margins. Inter-bank lending rates are inching down. So are the rates on commercial paper, which are like short term IOUs businesses use to manage their cash flow. Spreads on default insurance policies known as credit default swaps have also edged lower.
But as a general matter, the credit markets haven't had the thaw that policymakers had been hoping for. The yield on long-term Treasuries, which are used to set the rates on many fixed mortgages and are considered the safest of investments because they are backed by the U.S. government, are up to 3.98 percent. The average 30-year fixed mortgage rose to 6.28 percent Wednesday, according to Bankrate.com. Last week, it was 5.82 percent.
"We will continue to use all the tools at our disposal to improve market functioning and liquidity to reduce pressures in key credit and funding markets," Bernanke said. "Stabilization of the financial markets is a critical first step, but even if they stabilize, as we hope they will, broader economic recovery will not happen right away."
Investors didn't need Bernanke or the Beige Book to tell them the economy was in decline.
The Problem At Lehman Brothers
For the first time, Bernanke offered some explanation as to why the Fed and the Treasury allowed investment bank Lehman Brothers to fail in September.
Critics have said that Lehman's failure made the crisis that much worse and, because Lehman was a force in the commercial paper market, put a crimp in businesses' ability to finance themselves when Lehman disappeared. Bernanke said the Fed and Treasury were trying to find someone to buy the firm but it just wasn't possible. Unlike American International Group, which had collateral to put up, Lehman did not, he said.
"The firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid," he said. "And the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman's acquisition by another firm. Consequently, little could be done except to attempt to ameliorate the effects of Lehman's failure on the financial system."
Bernanke said that the $700 billion bailout program that Congress passed earlier this month provided the Fed and Treasury with better choices. He said that in the future, the Treasury will have the tools it needs to prevent the failure of a financial institution like Lehman.
Boosting The Banks
This fresh concern about the economy comes just a day after the Bush administration set in motion the largest government intervention in the American banking system since the Great Depression. On Tuesday, the Treasury formally announced that it would be injecting $250 billion into thousands of the nation's banks. The Treasury is going to buy stakes in the banks in order to restore confidence in the markets and convince the banks themselves that it was safe to start lending again.
The program, which will begin this week, is meant to be a straightforward way to beef up thinning bank reserves. Many banks have been running on the cash equivalent of fumes because of their bad bets on mortgage-related investments. The concern about reserves is one of the reasons banks have been loath to lend to one another. They have been worried that once they lend out money, they won't get it back — a mindset that has frozen the world's credit markets. In spite of the cash infusion and government guarantees of senior debt, that mindset hasn't changed much.
Treasury Secretary Henry Paulson clearly saw such an obstacle coming. On Tuesday morning when he announced the capital infusion plan, Paulson warned the bankers against stashing away the new cash. They need to actually use the money they were getting from the government, he said.
"We must restore confidence in our financial system," Paulson said. "The needs of our economy require that our financial institutions not take this new capital to hoard it but to deploy it."
While the Treasury's program has taken care of liquidity and fears of solvency, just how much banks are in the red — how much toxic debt they are carrying on their books — is still an unknown. It is unclear how various financial institutions will measure delinquencies and write-offs and investors will be wary until that happens.
Bush Sees Recovery In 'Long Run'
President Bush met with his Cabinet on Wednesday morning and said that Americans will need to be patient. The steps his administration and global leaders have taken in recent weeks will stem the damage of the crisis, he said, adding that he was confident "in the long run, that this economy will come back."
The last time the Treasury waded into the banking system in this way was in the 1930s. That's when the government set up the Reconstruction Finance Corp. to make loans and buy stakes in distressed banks during the Great Depression. The price tag at the time: $1.3 billion. The government eventually got out of the banking business when the economy stabilized. The government sold the stock it held to private investors and the banks themselves. That's expected to happen in this case as well.
"Bursting bubbles can be an extraordinary and costly phenomenon for the economy," Bernanke said, in what could only be seen as an understatement given the events of the last couple of weeks.
Copyright 2022 NPR. To see more, visit https://www.npr.org. 9(MDAzMjM2NDYzMDEyMzc1Njk5NjAxNzY3OQ001))
