WASHINGTON – The Federal Reserve and Treasury Department struggled Monday to limit the fallout from an upheaval among the country’s largest investment banks as they moved on to their next challenge – engineering a $75 billion private rescue of the nation’s largest insurance company.
The insurer, American International Group, faces a cash crunch that grew more severe Monday night when major credit-rating agencies warned investors that the company could have greater difficulty meeting its obligations. It was unclear whether the downgrades by the agencies would force AIG to post additional collateral at a time when it is having difficulty raising money.
Investors sent the Dow Jones industrial average plunging more than 500 points, or 4.4 percent, for the biggest point loss since the Sept. 11 terrorist attacks seven years ago. About $700 billion in shareholder value disappeared in a single day of trading.
The wrenching reshaping of Wall Street – which over the weekend included the demise of one big firm and sale of another – also pushed the value of the dollar lower. It sent the price of crude oil below $100 a barrel for the first time since Feb. 15 as traders bet a global downturn would reduce the demand for energy.
Wall Street’s biggest shakeout since the Great Depression stems from a collapse in housing prices, which spread losses among firms that bet on securities linked to mortgages. Twice in the past year, regulators intervened to save financial firms and prevent further erosion in the housing markets. But over the weekend, officials drew the line at rescuing Lehman Brothers, which Monday filed for bankruptcy protection.
“We had a very, very tough day on the market,” said Art Hogan, chief market analyst at Jefferies & Co. “Investors are anxious about the spillover effect of Lehman and what is the next shoe to drop.”
As investors digested the news, some economists worried whether Wall Street’s troubles were spilling over into other parts of the economy, renewing pressure on the Federal Reserve to cut interest rates when it meets today.
Fed leaders, however, are unlikely to cut rates for now.
In the meantime, Treasury Secretary Henry M. Paulson Jr. signaled Monday that taxpayer funds could still be used broadly to “maintain the stability and orderliness of our financial system” but that he was pressing healthier Wall Street firms and commercial banks to join together to assist in rescuing individual firms – much like the purchase of Merrill Lynch on Sunday by Bank of America.
Goldman Sachs, for instance, was asked by the Federal Reserve Bank of New York to help AIG, a $1 trillion-asset insurance company that serves 74 million consumers in 130 countries. AIG had been heavily involved in the business of issuing complex insurance contracts to investors in securities backed by mortgages, and the collapse of subprime and other home loans threatened to hobble the company and trigger a chain reaction.
J.P. Morgan Chase, which is serving as AIG’s financial adviser, was seeking support for a credit line of $70 billion to $75 billion that would involve multiple lenders, spreading the risk, according to two sources familiar with the discussions. New York’s governor, meanwhile, said his state would allow AIG to use $20 billion from its own insurance subsidiaries. By posting the assets as collateral, AIG can borrow money to run its day-to-day operations, said Democratic Gov. David A. Paterson. The move required special dispensation from state insurance superintendent Eric R. Dinallo.
A deal to rescue AIG may have to come quickly now that Standard & Poor’s and Moody’s Investors Service have lowered their credit ratings for the firm. The Fed has maintained that it will not offer AIG a bridge loan or other direct injection from the government, according to sources familiar with the conversations. AIG executives huddled at their Manhattan headquarters over the weekend with potential private investors including J.C. Flowers, Kohlberg Kravis Roberts, and TPG as well as Paterson’s representatives, including Dinallo; AIG was also talking to Warren E. Buffett’s Berkshire Hathaway.
“I don’t think anybody is going to lend that amount of money at terms that are anywhere near economically feasible without a backstop, without some form of guarantee, say by the Fed or another party,” said Donn Vickrey of Gradient Analytics, who has been warning of trouble at AIG for months.
Vickrey said it appeared the Fed was playing a game of chicken with Wall Street, trying to pressure firms with a big stake in AIG’s continued viability to step up to the plate.
AIG’s stock fell 61 percent, to close at $4.76, Monday.
Stephanie Marquis, spokeswoman for Washington Insurance Commissioner Mike Kreidler, said 22 AIG companies sell annuities and property and casualty insurance in the state. None is based in Washington, she said, so the state is relying on regulators in New York and other places to monitor efforts at shoring up the parent company’s finances.
The subsidiaries rank eighth among Washington’s property and casualty insurers, with about 3.4 percent of the market, Marquis said. They rank fourth in annuity sales, with 5.7 percent of the market.
In the event AIG or any subsidiaries are liquidated, Marquis said, a Washington Guaranty Fund levy on other insurers would protect policyholders.
Stocks’ plunge Monday showed that investors remained nervous. Shares opened lower but generally traded in the same range until the last hour of trading – when a 300-point drop in the Dow became a 504.48-point rout, bringing it to 10,917.51, moving below the 11,000 mark for the first time since mid-July. The technology-heavy Nasdaq was down more than 3.5 percent, and the Standard & Poor’s 500-stock index was down 4.7 percent.
The financial sector was among the hardest hit. Bank of America closed down 21 percent, while Wachovia fell 25 percent. Goldman Sachs and Morgan Stanley, the two remaining survivors of what were once Wall Street’s Big Five, report quarterly earnings this week – and closed down 12 and 14 percent respectively.
Although it was a horrible day for the market, it was no worse than Treasury and Fed officials had expected when they declined to intervene to save Lehman. Indeed, officials said they were pleased that the credit markets seemed to generally to function alright.