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September 16, 2008

The sky is falling!

Posted: 01:23 PM ET

Monday was the single worst day on Wall Street since a big stock tumble in the wake of the 9/11 attacks on America seven years ago. The Dow Jones Industrial Average stock index fell a whopping 504 points, a loss of almost four percent. The more representative S&P 500 index dropped almost five percent, while the tech-heavy NASDAQ Composite index closed 3.6 percent lower.

The average American might be left asking just one question today: Why? After all, there was no national disaster yesterday, Hurricanes Gustav and Ike didn’t do nearly as much damage as expected. Oil prices dipped under $100 a barrel for the first time in many months.

Shouldn’t we be celebrating?

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Unfortunately, while the hurricanes were blowing through the Gulf, a perfect storm was descending on the stock market, fueled by bad bets on America’s now troubled housing market.

The financial titans on Wall Street put all their eggs into a basket of mortgaged-back securities and other complex derivatives that depend on home interest payments for income flows.

It was a good ride, until home values started to plummet across the country, sticking homeowners with expensive subprime loans on properties worth a lot less than their mortgages. That has forced many American homeowners to fall behind on their mortgage payments, or worse, filing for foreclosure on their homes.

Things came to a head last week with the government’s unprecedented takeover of mortgage giants Fannie Mae and Freddie Mac that unsettled many. But over the weekend, U.S. Treasury Secretary Henry Paulson refused to help bail out Wall Street’s big banks in trouble over their bets on bad real estate.

Here’s a summary of what has transpired so far:

1. Lehman Brothers has filed for Chapter 11 bankruptcy. The 158-year-old investment bank has accumulated debt totaling $613 billion. It failed to secure a takeover by British bank Barclays or Bank of America over the weekend, and had no choice but to throw in the towel. Lehman Brothers says it’s protecting its assets and maximizing its value by declaring bankruptcy.

2. Merrill Lynch has agreed to a merger with Bank of America. Once B-of-A decided to end talks with Lehman Brothers, it turned its attention to Americans' largest brokerage and quickly struck a deal to acquire it for $50 billion in stock - a deal that effectively ends Merrill’s independence. Merrill had posted losses of over $17 billion this year.

3. The American International Group announced plans to restructure. AIG - one of the world’s largest insurers - said it would sell off part of its business to help recoup losses from the subprime mortgage crisis. In the past 9 months, AIG has lost more than $18 billion. On Monday night, three credit rating agencies downgraded their ratings for the company, making it harder to raise the funds to get it out of the red.

To put things in perspective, there were five major investment banking firms dominating deals on Wall Street at the start of 2008. Now, nine months in only two remain.

Bear Stearns closed shop earlier in the year in a government-assisted takeover by JP Morgan. Now that Lehman is gone and Merrill is swallowed up by a larger commercial bank, only Morgan Stanley and Goldman Sachs are left to arrange the big deals on Wall Street.

Many believe the current turmoil hitting the financial system is the worst since the Great Depression.

Why does this all matter to you?

More than half of Americans are invested in some way or shape in the stock market, through 401(k) plans, Individual Retirement Accounts and mutual funds. Many of these funds are tied to indices that are heavy with financial stocks now in trouble. So, stay tuned ad the turmoil on Wall Street sends ripples out onto Main Street.

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Filed under: Finance


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About this blog

Clark Howard helps you become a wise consumer. We know you're busy, and that's why Clark's tips are quick and effective. He'll arm you with the information you need to make smart choices. During these tough economic times, Clark wants to help you save more, spend less and avoid getting ripped off!