Dow falls 504; more volatility is ahead

By Charley Blaine and Elizabeth Strott

The Dow Jones industrials suffered their biggest point loss since the Sept. 11, 2001, terror attacks today.

The major averages fell to their lowest levels in two years because of the collapse of Lehman Bros. (LEH, news, msgs) and deepening concerns about the future of insurance giant American International Group (AIG, news, msgs) and regional banking company Wachovia (WB, news, msgs).

Tuesday could bring another day of big volatility.

At the close, the Dow Jones industrials were down 504 points, or 4.4%, to 10,917, its lowest close since July 2006. The Standard & Poor's 500 Index was down 58 points, or 4.6%, to 1,194, and the Nasdaq Composite Index was down 81 points, or 3.6%, to 2,180.

The Nasdaq's close was its lowest since March 10.

The Dow's point loss was its worst since Sept. 17, 2001, the first day of trading after the Sept. 11, 2001, terror attacks. The percentage loss was its worst since July 2002.

Futures trading tonight shows the Dow opening down an additional 120 points on Tuesday. The S&P 500 could drop another 15 points. Japan's Nikkei 225 index and South Korea's Seoul Composite Index were down 4.6% and 6.3% in early Tuesday trading.

Three forces will ultimately determine how the markets fare:

• The uncertainty and the potential big problems with AIG are continuing. Late Monday, three ratings agencies -- Standard & Poor's, Moody's and Fitch Investors -- downgraded AIG, citing the damage to the company's stock price and continuing problems with mortgage-related investments. Ratings downgrades could force the company to raise billions in new capital very rapidly. The odds of success aren't high.

• Goldman Sachs, the largest and, arguably, the most important U.S. investment bank, reports its fiscal-third-quarter earnings.

• The Federal Reserve will meet to discuss interest rates. There's growing speculation that the central bank will cut its key federal funds rate, now at 2%, to 1.75% or lower. The announcement will come around 2:15 p.m. The Fed did add $70 billion in bank reserves today, its biggest such move since after 9/11, to reverse a surge in borrowing costs spurred by the Lehman Bros. collapse.

AIG's position is extremely difficult

The AIG issue may be the most important, especially given the downgrades tonight.

Wall Street and the Bush administration are scrambling to find a way to shore up AIG, the world's largest insurance company. AIG, whose shares fell 60.8% to $4.76 today, is far larger than Lehman Bros. and does business in just about every country in the world.

In addition, it is heavily exposed to problems in the subprime mortgage market and to problems with securities backed by mortgages.

The government asked Goldman Sachs (GS, news, msgs) and Morgan Stanley (MS, news, msgs) to try to raise $70 billion to 75 billion in short-term financing to help AIG survive the current crisis. Bloomberg News reported late today that meetings were being held to try to understand the problem clearly.

So far, the government is unwilling to participate directly an AIG rescue. That position caused a number of potential investors, including TPG Group and Kohlberg, Kravis Robert & Co., to back away from investing in AIG.

Earlier today, New York State Governor David Patterson authorized AIG to access $20 billion of assets held by its subsidiaries so AIG can use them as collateral to borrow cash.

AIG's problem is not a liquidity issue; rather, if the company gets downgraded, it will have trouble raising capital. AIG hired JPMorgan Chase to help advise the company to prevent a downgrade, CNBC reported Sunday.

An important support level has been breached

With the today's big sell-off, the Standard & Poor's 500 Index dropped below 1,201.

The 1,201 level had been its intraday low for the year, which came on July 15, and traders had watched it carefully because it was seen as an extremely important support level.

Support levels are levels for stock prices and indexes that generate new buying to support prices.

Now that the index has dropped under 1,201, the next support level is around 1,175, and it could drop further.

A big, nasty sell-off

Traders had expected an ugly day after Lehman Bros. said late Sunday that it would file for bankruptcy protection. The market sank badly at the open, with the Dow dropping more than 300 points within 20 minutes of the start of trading as Wall Street tried to cope with the collapse of Lehman, AIG's problems and the sale of Merrill Lynch (MER, news, msgs) to Bank of America (BAC, news, msgs) for a reported $29 a share or $50 billion.

Lehman shares sank 94% to 21 cents after the bankruptcy filing in New York.

Merrill Lynch shares opened up as much as 23% after announcing it was selling itself to Bank of America. But the gains faded at the close to just 1 cent to $17.06.

Bank of America's shares were down 21% to $26.55 as many investors clearly wondered if the deal made sense. Bank of America, for its part, insisted it was a great deal.

Wachovia shares were down 25% to $10.71 and have fallen 28% this month alone. It wasn't clear if Wachovia's problems with bad mortgages were worsening or whether short-sellers were attacking the stock. Short-sellers borrow shares from brokers and sell them. Their profit comes from buying the shares back and returning them.

Twenty-nine of the 30 Dow stocks were lower, along with 486 S&P 500 stocks and 3 stocks in the Nasdaq-100 Index ($NDX.X). The Nasdaq-100, which tracks the largest Nasdaq stocks, was down 62 points, or 3.5%, to 1,705.

The only Dow stock with a gain: Coca-Cola (KO, news, msgs), up 0.5% to $54.75.

• Get free, real-time stock quotes on MSN Money

Financial stocks were the weak link. The Select Sector SPDR-Financial (XLF, news, msgs) exchange-traded fund, which tracks the stocks in the financial sector of the S&P 500, was down 9.7% to $19.09.

Airlines were the one group of stocks that were clear winners, thanks to falling oil prices. American Airlines parent AMR Corp. (AMR, news, msgs), up 8.8% to $11.30, was the top stock in the Dow Jones Transportation Average ($DJT). The index was down 117 points, or 2.3%, to 4,957.

Crude oil closed down $5.47 to $95.71 a barrel this afternoon, its first close under $100 since March, after initial reports suggested that the network of oil and gas platforms and refineries along the Gulf Coast survived Hurricane Ike with modest damage.

Energy shares tumbled; the Select Sector SPDR-Energy (XLE, news, msgs) ETF fell 7.7% to $63.65.

After the close, Hewlett-Packard (HPQ, news, msgs) said it would cut its work force by 7.5%, or 24,600, over the next three years to realize savings from its recent purchase of Electronic Data Systems. HP shares, down 3.5% to $45.33 in regular trading, moved up 0.8% to $45.70 in after-hours trading.

Energy prices -- New York close

	Mon.	Fri.	Chg.	Month chg.	YTD chg.
Crude oil (NYMEX) (per barrel)	$95.71	$101.18	-$5.47	-17.11%	-0.28%
Heating oil (per gallon)	$2.7912	$2.9391	-$0.1479	-12.28%	5.35%
Natural gas (per million BTU)	$7.3740	$7.3660	$0.0080	-7.16%	-1.46%
Unleaded gasoline (per gallon)	$2.5614	$2.7696	-$0.2082	-14.90%	2.83%

Lehman files for bankruptcy

Shares of Lehman plunged $3.43, or 93.8%, to 22 cents per share after the corporate parent filed for bankruptcy protection.

Lehman said it is exploring the sale of its broker-dealer operations and is in advanced discussions to sell its investment-management business, Neuberger Berman. Lehman said its subsidiaries will continue to conduct business; customers of Lehman and Neuberger Berman "may continue to trade or take other actions with respect to their accounts," its Web site said.

The company employs more than 25,000 people around the world.

Lehman's bankruptcy petition said it has debts of $613 billion compared to assets of $639 billion, making it bigger than WorldCom's bankruptcy in July 2002, which had $104 billion in assets. Lehman has more than 100,000 creditors.

A deal between Lehman, the fourth-biggest investment bank, and Bank of America fell apart after the Treasury Department stood firm in its position that it would not fund any sort of bailout for the company. The same held for British bank Barclays (BCS, news, msgs). Barclays is still interested in Lehman's U.S. broker-dealer business, The Wall Street Journal reported.

• Reaction: Fed wants out of bailing out

Lehman's holding company filed for bankruptcy protection, not the main broker-dealer.
A broker-dealer can file for bankruptcy but can only file for Chapter 7, or be liquidated by the Securities Investor Protection Corp., said John Kaplan, a bankruptcy lawyer in Seattle. It cannot file a Chapter 11. The panic that many people are feeling who are retail customers is 'what's going on with what's in my brokerage account?' In theory, this should be unaffected by the holding company's bankruptcy filing."

Is there any reason to actually own Lehman shares going forward? In most case, the shareholders are wiped out, Kaplan said.

Why Bank of America wants Merrill Lynch

After walking away from the acquisition of Lehman, Bank of America turned to Merrill Lynch (MER, news, msgs), agreeing to buy the brokerage for $50 billion, or $29 per share, in stock.While the $29 price for Merrill represents a 70% premium to Friday's closing price of $17.05, it is a mere 30% of its all-time closing high. Shares of Merrill fell 12% on Friday as worries about its future mounted. Merrill stock is down more than 68% over the past year.

Bank of America CEO Ken Lewis said today that Merrill Lynch was attractive because its wealth-management is the best in the world and would complement the banking giant's existing operations.

There was chatter over the weekend that Treasury Secretary Hank Paulson was the key force in Merrill's decision to sell, but many people on Wall Street believe Merrill's move was based on a combination of pressures, some from Paulson and the Federal Reserve and some based on fears that Merrill would be the next domino to fall.

Merrill and Bank of America said the deal will be 3% dilutive to earnings in 2009 and break even in 2019; the companies expect the merger to be completed by the end of the first quarter in 2009.

"I think the Merrill Lynch deal is terrific for the market," Don Drapkin, Lazard International vice chairman, told CNBC. Drapkin suggested that, with Merrill in strong hands, world markets could withstand the loss of Lehman.

Wall Street is now left with two giant brokerages: Goldman and Morgan Stanley (MS, news, msgs). And they weren't immune to the sell-off. Goldman Sachs fell 12.1% to $135.50. Morgan Stanley fell 13.5% to $32.19.

Many analysts believe it unlikely that either will remain independent in the next few years.

"The majority of investors think that Morgan and Goldman are going to have a tough time surviving without a consumer bank behind them, and unfortunately in this atmosphere, perception is 90% of the reality," MadisonPropTrading's Chris Conefry explained. "It's really impossible to say right now. The two banks that should be rewarded for having the least exposure to this debacle -- Goldman and Morgan -- are still being penalized because nobody thinks they can survive this because of their business models. That alone should tell you what the attitude is toward financials in this atmosphere."

Both Lehman and Merrill have struggled recently because of exposure to risky mortgage-backed securities; in July, Merrill reported a second-quarter loss of $4.65 billion and wrote down $9 billion in bad mortgage bets.

"Anyone else who has these toxic assets, if they haven't made a full confession, they better do it now," Matt McCormick, portfolio manager at Bahl & Gaynor Investment Counsel, told Reuters. "These assets may be hard to unwind, but they can unwind your firm. Lehman tried to deny reality until the bitter end."

Morgan Stanley this morning said it believes a potential acquisition by JPMorgan of Washington Mutual would be a strategic positive for JPMorgan (JPM, news, msgs) according to theflyonthewall.com. WaMu would give JPMorgan a presence in the West and Southeast and increase core deposit funding to 32% from 28% of managed earnings assets.

JPMorgan closed down 10.1% to $37.

Fed takes steps to help

The Federal Reserve late Sunday announced plans to help "provide additional support to the financial markets," including an expansion of its lending facilities to brokerages. The Fed opened its lending window to non-banks after the Bear Stearns rescue in March, but no investment banks had tapped the window as of Wednesday.

• Read the Fed's statement

"Today we are looking forward," the Treasury's Paulson said in statement released Sunday.

"We are seeing a fundamental redefinition of the financial landscape. It is not happening according to a master plan; it is happening because of a series of crises," Mohamed El-Erian, Pimco co-CEO, told CNBC. Pimco is the world's biggest bond fund. "We are seeing a shift in a policy response from focusing on institutions to starting to focus on the system."

A group of 10 banks also took action to help the liquidity picture for the financial markets. The consortium includes JPMorgan and Goldman Sachs, each of which will contribute $7 billion to the loan program. Bank of America, Barclays, Citigroup (C, news, msgs), Credit Suisse (CS, news, msgs), Deutsche Bank (DB, news, msgs), Merrill, Morgan Stanley and UBS (UBS, news, msgs) are also in the group.

Over the weekend, Lehman hired law firm Weil, Gotshal & Manges to work on a potential bankruptcy filing. Weil is the law firm that advised Drexel Burnham Lambert when it filed for bankruptcy protection in 1990.

Lehman's problems escalated last week after Korea Development Bank walked away from talks, forcing the company to announce plans to slash its dividend, sell 55% of its investment-management business and spin off some of its commercial real-estate portfolio. Lehman also pre-announced a $3.9 billion loss for the third quarter.

Jitters have plagued the financial sector for a year. Bear Stearns was rescued by the Federal Reserve and JPMorgan six months ago, in a deal that delivered Bear to JPMorgan for a mere $10 per share. Bear stock had traded at $170 per share in March 2007.

The Treasury Department took over beleaguered mortgage companies Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs) a little more than a week ago, sending their shares reeling.

In an interview on Sunday, former Fed chief Alan Greenspan sounded supportive of the course federal authorities have set.

"There are certain types of institutions which are so fundamental to the functioning of the movement of savings into real investments in an economy that on very rare occasions, and this is one of them, it's desirable to prevent them from liquidating in a sharply disruptive manner," Greenspan said on ABC's "This Week" with George Stephanopoulos.

"This is a once-in-a-half-century, probably once-in-a-century type of event,'' Greenspan said.

Andy Rosenbaum contributed to this story.

Short hits from the markets -- 4 p.m.

	Mon.	Fri.	Chg.	Month chg.	YTD chg.
Treasurys
13-week Treasury bill	0.810%	1.460%	-0.650	-52.07%	-74.20%
5-year Treasury note yield	2.601%	2.956%	-0.355	-15.80%	-24.72%
10-year Treasury note yield	3.483%	3.730%	-0.247	-8.65%	-13.68%
30-year Treasury bond yield	4.152%	4.326%	-0.174	-5.89%	-6.88%
Currencies
U.S. Dollar Index	79.395	79.495	-0.100	2.45%	3.52%
British pound in dollars	$1.8002	$1.7995	0.0006	-1.17%	-9.50%
Dollar in British pounds	£0.5555	£0.5557	-0.0002	1.18%	10.50%
Euro in dollars	$1.4278	$1.4282	-0.0004	-2.70%	-2.31%
Dollar in euros	€ 0.7004	€ 0.7002	0.0002	2.77%	2.37%
Dollar in yen	104.28	104.35	-0.07	-4.13%	-6.77%
Canadian dollar in U.S. dollars	$0.935	$0.936	-$0.0004	-0.56%	-5.82%
U.S. dollar in Canadian dollars	$1.070	$1.069	$0.0013	0.57%	6.19%
Commodities
Gold	$787.00	$764.50	$22.50	-5.77%	-6.09%
Copper	$3.1365	$3.1940	-$0.06	-7.40%	3.14%
Silver	$11.1350	$10.7950	$0.34	-18.76%	-25.37%
Corn	$5.6200	$5.6325	-$0.01	-1.10%	23.38%
Crude oil (NYMEX) (per barrel)	$95.71	$101.18	-$5.47	-17.11%	-0.28%