Financial System Suffers Relapse
Shattering Lull, Fears of Deep Recession Roil Markets

By Neil Irwin and Renae Merle
Washington Post Staff Writers
Friday, November 21, 2008

The financial system, which had recently shown glimmers of improvement, is unraveling again.

After a few weeks in which credit started flowing more freely through banks, giving relief to financial markets, prices continued to plummet yesterday for all but the safest investments, dragged down by fears of a deeper and longer recession than even many pessimists had expected.

Investors were so eager to move money into ultra-safe U.S. Treasury debt yesterday that they were effectively paying the government to hold on to their cash.

Meanwhile, the stock market fell nearly 7 percent yesterday, as measured by the Standard & Poor's 500-stock index, now at its lowest level since 1997. Financial companies have been particularly hard hit, especially Citigroup, whose shares lost half their value this week.

Saudi Prince Alwaleed bin Talal, the largest shareholder in the company, announced a new investment in the firm as a show of support, following a major sell-off Wednesday. But it wasn't enough to stanch the bleeding, as the shares fell an additional 26 percent yesterday.

The bank has asked the Securities and Exchange Commission to reinstitute its temporary ban on short-selling shares of financial firms, according to an industry source familiar with the matter who spoke on condition of anonymity because the communications with the bank were private.

Citigroup issued a statement yesterday insisting that its health is strong. The company "has a very strong capital and liquidity position and a unique global franchise," it said. "We are focused on executing our strategy, including our targeted expense and legacy asset reductions, and we believe the benefits will be seen over time."

A Citigroup spokesman declined to comment on reports that the company is considering a sale.

Citigroup is being pummeled, but the entire sector has been under pressure, said Sean Ryan, a banking analyst with New York-based Sterne Agee. "It is just a hideous environment for anyone," Ryan said.

The relapse in the markets poses a predicament for economic policymakers at the Treasury Department and Federal Reserve, who have used extraordinary tactics to try keeping the financial system glued together. The Treasury has injected more than $200 billion into banks, while the Fed is lending directly to companies by buying their short-term debt.

These were among the steps that helped achieve a measure of healing in recent weeks, particularly in making banks more confident about lending to each other. Financial indicators show that conditions remain better than they were in October, but now, confronted with the prospect of a deep recession, investors are bracing for a new round of damage to financial companies.

Citigroup was a major concern yesterday, but the misery on financial markets had no single cause. In Washington, talks broke down over a government rescue of major automakers, raising the specter of massive job losses. The broader economic picture also darkened with a report yesterday that more Americans filed for unemployment insurance benefits last week than in any week since 1992.

"The economic news continues to be quite bleak," said Peter Cardillo, chief market economist with New York-based Avalon Partners. "We have a market that is pricing in a global recession that will probably last longer than most people anticipated."

And investors are coming to grips with the limitations of the government's response. Treasury secretary Henry M. Paulson Jr. said this week that he would not seek the remaining $350 billion of the $700 billion rescue package Congress approved last month, instead leaving the balance for the Obama administration to use come January.

Paulson also said last week that he would not be using any of the bailout money to buy up troubled assets from the books of banks, so hope has dissipated that the market for complex mortgage securities will start functioning soon. Investors had hoped that government purchases would jump-start that market by establishing new prices that could open the door for the return of regular buying and selling.

Wall Street interpreted Paulson's comments to mean that the financial rescue is on hold until President-elect Barack Obama's inauguration. And Wall Street was none too pleased.

"It's a complete loss of confidence," said Allen Sinai, president of Decision Economics, a consultancy. "We made our errors in the 1930s by letting the banking system go down. . . . We haven't done that. But history will write that we made a lot of other mistakes and left ourselves with a modern-day counterpart to the 1930s situation."

Bank lending, which increased steadily in October as financial firms became more confident that the rescue would work, has fallen recently, according to Federal Reserve data, suggesting that credit will remain constrained in the near future.

J.P. Morgan Chase is expected to lay off 10 percent of its investment banking staff, or about 3,000 people. Goldman Sachs shares fell to below the price at which they were first sold to the public almost a decade ago.

The simplest measure of the health of the financial system is the price the U.S. government must pay to borrow money by issuing bonds. When investors are fearful, they are willing to accept low rates to lend to the government just to guard against losses or the risk that they won't be able to access cash.

Yesterday, investors were petrified. Rates on all types of U.S. government debt fell to all-time lows; the Treasury can now borrow money for two years at a rate of less than 1 percent, and can borrow money for 30 years for less than 3.5 percent.

For 30-day Treasury bills, the rate is effectively zero, which means, with transaction fees, that investors are essentially paying for the government to take money out of their hands for a month.

Conversely, rates soared on all types of risky debt. Rates have spiked on "commercial-mortgage-backed securities," which are loans against office buildings and other commercial property, and on debt owed by companies that are considered uncertain bets.

"The market is hungering for stability, and it isn't getting it from the government. They're not getting it from the economy, and their only recourse is to sell," said Matt McCormick, portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel.

The Treasury said yesterday that it stands ready to buy assets from the Reserve Fund's U.S. Government Fund, a money-market mutual fund with $6.3 billion in assets, under a temporary program it initiated last month to bolster money-market funds. That would make it easier for the fund to handle redemption requests by its investors.

Also casting a pall on the broader market was uncertainty about the future of the U.S. automakers. With Congress struggling to reach accord on a rescue of General Motors, Ford and Chrysler, investors were weighing the prospect of further job losses among autoworkers and auto parts suppliers and of ripples through the financial system.

"The market is fearful of the consequences if Detroit is allowed to fail and what that would mean in terms of further economic decay," said Cardillo, of Avalon Partners.

The economic and financial distress continues to drive down prices of fuel and other commodities.

Crude oil closed below $50 a barrel yesterday for the first time since 2005, and has now has fallen more than 65 percent from its peak of $147 a barrel this summer. Some analysts are forecasting prices of $35 to $45 a barrel by year's end, levels that would have been unthinkable just this summer, reflecting sharply declining global demand.

Traders are ignoring triggers that would have traditionally sent prices up, including a Saudi-owned supertanker seized by pirates off Somalia, which could disrupt shipping routes, said Addison A. Armstrong, director of market research at Connecticut-based Tradition Energy. "There are bullish factors out there," he said, "but the market is just ignoring them because they are more focused on the collapse of the financial system."

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