Economy Shows New Signs Of Stress
Merrill Lynch Loss, Home-Sales Data Expose Weaknesses

By Neil Irwin and Tomoeh Murakami Tse
Washington Post Staff Writers
Thursday, October 25, 2007

Many of the nation's biggest companies have cut back their sales expectations in recent days and the financial system is showing signs of new stress, evidence that the U.S. economy is more threatened by the sharp downturn in housing than it appeared to be only a few weeks ago.

The investment firm Merrill Lynch yesterday reported its first quarterly loss in six years and said the value of assets on its books had fallen $7.9 billion. The National Association of Realtors reported that the number of existing homes sold in September was the lowest in the eight years the data have been tracked.

The developments were the latest to undermine investors' confidence that the August financial crisis has passed since the stock market reached an all-time high Oct. 9. Stocks fell in early trading yesterday, with the Dow Jones industrial average down about 200 points before recovering most of its loss by the end of the session.

"On the fundamental economics, there's a perception that things are getting worse," said Kenneth Kim, an economist at Stone & McCarthy Research Associates. "On the credit-market problems, people had started to think the worst was behind us. Now they think that's not necessarily the case."

The problems started last week in the banking sector. Citibank, Bank of America and Wachovia each reported disappointing earnings, mostly from losses on a variety of credit products. The banks indicated that their portfolios of home loans, credit card debt and some forms of corporate debt were worth less than was previously thought, and led to write-downs of $2.2 billion at Citigroup, $4 billion at Bank of America and $1.3 billion at Wachovia. Bank of America said last night that it would lay off 3,000 employees at its investment-banking division and reevaluate the unit's strategy.

Losses of that size are often manageable for such large institutions, but the write-downs added to worries on Wall Street and at the Federal Reserve that U.S. banks may be even more exposed to the problems in the world credit markets than even the banks had previously realized.

Fed leaders have been counting on the banks to be the economy's shock absorber by making capital available to consumers who wish to spend and businesses that want to expand. If the banks think they no longer can trust the value of their assets and liabilities, then they could become less willing to lend, a prospect that could cause more damage to the economy.

The Fed's policymaking committee is to decide Wednesday whether to intervene by cutting a key interest rate, but the group's signals have been mixed. In a speech last week, for example, Chairman Ben S. Bernanke said that the U.S. economy, aside from the housing sector, has been holding up well but also that damage to the financial system continues to pose risks and that the outlook is more uncertain than it had been.

Barely a week ago, futures markets were indicating that investors thought the Fed would probably stand pat and not cut rates, but by yesterday, the prediction had reversed.

With companies still filing third-quarter earnings reports, bad news has come from many sectors of the economy.

Last week, the construction-equipment maker Caterpillar warned that the housing downturn was spreading to other parts of the economy, raising fears about the economy's strength and its ability to avert a recession. Capital One Financial of McLean, meanwhile, last week posted its first-ever quarterly loss and said it had an increasing number of delinquencies and defaults in both the credit card and auto finance sectors.

On Tuesday, luxury leather-goods maker Coach, citing a "weakening retail landscape," said it expects sales at its stores in the United States to rise only moderately.

The $2.2 billion loss posted by Merrill Lynch yesterday was far worse than what it forecast less than three weeks ago. The investment firm said it had to write down mortgage-backed assets by $7.9 billion, revised from an earlier estimate of $4.5 billion. Some investors saw it as a sign that the financial industry still may not have a full grip on problems related to risky, subprime loans.

"We got it wrong," Merrill's chairman and chief executive, E. Stanley O'Neal, said in a conference call with investment analysts. "We made a mistake. There were some errors of judgment made in the business itself and in the risk-management function."

O'Neal left the door open to further write-downs, saying the firm expected "market conditions for subprime mortgage-related assets to continue to be uncertain."

The National Association of Realtors reported that sales of existing single-family houses, townhouses, condominiums and co-ops declined 8 percent in September from August, to a seasonally adjusted rate of 5.04 million units. The pace is the lowest since the association began tracking such data in 1999. Sales were down 19.1 percent compared with September 2006.

The numbers reflect that home buyers continue to struggle to secure loans, especially those worth more than $417,000, as lenders tighten standards and increase costs for the larger loans, analysts said. The decline was expected to bleed into October and to be reflected in new-home sales figures scheduled to be released today. The association also reported that the housing inventory had increased and that median prices declined.

Combined with new data about flagging existing-home sales, Merrill Lynch's disclosure pushed U.S. markets sharply lower, though the major indicators regained most of their losses in the final hour of trading. Late-day rallies have been common in the past few months of volatile trading sessions.

The Dow Jones industrial average ended the day down less than a point, to 13,675.25. The broader Standard & Poor's 500-stock index fell 3.71 points, to 1515.88. The tech-heavy Nasdaq composite index fell 24.5 points, to 2774.76.

The turbulent market has spurred growing concern in Congress and forced lenders to curb the subprime loans that have been the subject of most of the recent foreclosures. Earlier this week, Countrywide Financial, the nation's largest mortgage lender, announced it would refinance or modify up to $16 billion in home loans through the end of 2008, including 52,000 subprime borrowers.

"I can't see a light at the end of the tunnel for declining home sales," said Stuart G. Hoffman, chief economist for PNC Financial Services Group in Pittsburgh. "Before we hit bottom, which may not be until next spring or summer, [the market] is going to be down another 5 to 10 percent from where we are now."

"Housing is a black hole, but it hasn't quite sucked in the energy of the rest of the economy," Hoffman said. "But my forecast is that when we close the books on this holiday season, this is not a holiday [retailers] are going to remember very fondly, probably the least profitable since 2001, 2002."

Staff writer Renae Merle contributed to this report.