What Paulson Is Trying to Do

Banks need a capital injection before they take their lumps.

ANDY KESSLER

Less than two weeks into it, the $700 billion Troubled Asset Relief Program (TARP) is stuck between a rock and a hard place. Next week, several hundred billion dollars of credit default swap (default insurance) payments on Lehman's debt default are due. No one quite knows who owes what and if they're good for it. Hence the urgency in Henry Paulson and Ben Bernanke's plan to inject $250 billion directly into bank balance sheets, which seems a necessary evil to get capital to the right place and help weaker banks save face. The credit markets agree -- so far.

Chad Crowe

Wall Street and banks live by short-term loans. But as a loan shark might say, right now, nobody wants to lend to nobody. The rate that banks charge each other, the London Interbank Offered Rate (Libor), has been trading so high above three-month Treasury-bill rates (on Monday it was 4.75% vs. 0.11%) that no one is lending. This so-called TED spread -- the difference between what banks pay and what the Treasury pays to borrow for three months -- signals the health of credit markets and has rarely been over 1% since the 1987 crash. The Treasury is clearly focused on this metric and needs to get it down to historic spreads. First it has to change the current mentality of "who wants to lend to the next Lehman or Wachovia?"

The original TARP plan was to buy all the bad loans, mortgage-backed securities and collateralized debt obligations (CDOs) currently weighing down bank balance sheets. That is still the right (and profitable) thing to do. History shows that well-capitalized banks eventually do lend since hoarding doesn't make money.

But here's the current dilemma: If Treasury pays more than market price for these distressed securities, it would look like a taxpayer gift to Wall Street. That's politically unfeasible. So Treasury has to pay the current distressed prices. (Despite this week's stock-market bounce, prices are still dropping on toxic CDOs.) But if Treasury pays current, fire-sale prices, it would lead to major write-downs at banks. Since most of these securities are collateral for other loans, and regulators force banks to have minimum capital requirements and cash on hand, any write-down in value immediately means new capital needs to be raised.

And then who would throw good money after bad? Sovereign wealth funds have already been burned. Dubai invested in Citigroup less than a year ago via preferred shares that convert into Citi stock at $32 to $37 per share. Citi is now around $18.

Other banks are still scrambling. Morgan Stanley's shares bottomed under $7 last Friday on fears that Mitsubishi UFJ Financial Group, a Japanese bank with $1.8 trillion in assets, would pull out of a previously announced deal to buy 21% of the company for $9 billion. Luckily for Morgan Stanley, the Japanese think long term and did the deal anyway, even though it makes no economic sense at the moment. Other U.S. banks wouldn't be so lucky.

So here we are with no interbank loans and no equity financing. Treasury would bankrupt banks if TARP buys securities at market prices, forcing them to do the impossible task of raising capital in an ugly environment.

The direct capital injection is a way to get unstuck. In effect, first Treasury injects money into bank's balance sheets, then buys the toxic loans at market prices. Even if there are write downs, banks will have enough capital to live. What about healthy banks like J.P. Morgan, Bank of America and perhaps Goldman, which don't need capital? They get it too. The Treasury is forcing every top bank to take the government investment. Why? Because if they didn't, the ones that do take the capital would look weak and loans to them would remain dry.

Is this the right thing to do? Probably not. Despite some limits on compensation, bad management stays in charge. Government investment in financial institutions will raise a gazillion temptations and conflicts of interest. Politicians won't be able to help themselves and will inevitably meddle. Just look at the pork loaded into the TARP bill. But it's the only thing to do at this stage. Next stop is full nationalization and no one wants that. Already the TED spread is coming in, dropping to 4.36 from 4.64. The market likes the plan, at least for now.

One concern: Won't cranking the monetary printing presses to finance all this lead to runaway inflation? Probably not. Remember that after the 1929 market crash and subsequent bank runs, 10,000 or roughly 40% of banks failed, $2 billion in deposits were wiped out and 30% of the money supply disappeared. So did a similar percentage of GDP. Today, bank deposits are mostly safe, but with $1 trillion in bank and Wall Street writedowns taken or soon to be taken on bad real estate securities, some multiple of that in money supply will vanish with the stroke of an accountant's pen. Restarting bank lending is the only way to top it back up.

Many questions remain: When will Libor rates and the TED spread go back to normal so lending can restart? Then, when does the government sell the preferred shares so we can return to a market economy? Can we put an expiration date on government programs? (Most New Deal institutions are still around.) Furthermore, what do we do with the returns on investment?

Thanks to deposit insurance, there are no huge bank runs going on. There is, however, a "loan run," meaning no one will lend to weak banks. Yes, it's distasteful for government to own any private enterprise, especially in finance. But if you hold your nose, the new TARP seems like a way to end this loan drought. There is no economy until this is fixed. Then we can start arguing about the inevitable reforms to come.

'Distasteful' Capital

A dangerous if necessary moment for U.S. markets.

The government's rescue plan moved into a new phase Monday night with the announcement that Treasury is injecting $125 billion into the country's nine largest banks. This amount -- as much as $25 billion each for the biggest -- seems to have stopped the financial panic for now by easing fears of insolvency. Another $125 billion is on the table for other banks that need capital on the same terms offered to the big boys.

AP

The good news here is that Treasury Secretary Hank Paulson has at last moved from promises to action, and credit markets have responded positively. But this is also a very dangerous moment. The government has taken ownership stakes in the largest banks in the land. This extraordinary intervention is perilous -- not least to the banks themselves -- unless it is limited in scope and time. Mr. Paulson called the capital injection "distasteful" but unavoidable, and we can't disagree. The trick is to ensure that neither he nor his successors develop a taste for politically directed credit.

Despite the risks, directly recapitalizing the banks is likely to prove a better tool than buying up "troubled assets," though the Treasury seems on course to do some of that too. Giving banks this additional capital cushion should give them some leeway to sell those assets at market prices without risking insolvency. At the same time, it avoids the vexing problem of how to price securities that the smartest minds in finance are having trouble assigning a value to.

And unlike buying dodgy mortgage paper, recapitalizing banks is something the government has done before and knows how to do, more or less. The FDIC has done so from time to time via open-bank interventions, and the Depression-era Reconstruction Finance Corp. recapitalized thousands of banks in the 1930s.

Under the program, banks that participate will pay 5% interest annually on nonvoting, senior preferred shares issued to Treasury. Treasury will also receive warrants to buy bank stock at the market price at the time of the capital injection. The warrants, equal to 15% of the face value of the preferred shares issued by the bank, offer some possibility of profit for the Treasury without being so dilutive to existing shareholders as to scare away private capital.

Most of the banks dragooned into participating Monday saw their share prices rise Tuesday on the news. J.P. Morgan Chase was the exception, reflecting a sense that it was forced to accept dilution that its balance sheet doesn't warrant. This market reaction suggests that the capital is a better deal than most banks could get on the open market, but not so good as to be a giveaway. The pricing is somewhat more generous to the banks than outside investors such as Warren Buffett have recently demanded.

Forcing the big nine -- Goldman Sachs, Morgan Stanley, Bank of America, Merrill Lynch, Citigroup, Wells Fargo, Bank of New York Mellon and State Street, in addition to J.P. Morgan -- to go in as a group may have been necessary to reduce the stigma of being first to the window. But the Treasury program is supposed to be voluntary and should operate that way in practice going forward.

Meantime, for the program to do the most good, someone needs to make sure that this capital is used to shore up the larger system, not just any banks that wants it, while also protecting taxpayers. In that connection, Mr. Paulson still needs a heavyweight to run this thing. Acting Assistant Secretary Neel Kashkari seems smart and capable, but whether he can resist the imprecations of Congress to use this program to serve its parochial ends is another matter.

House Financial Services Chairman Barney Frank is on record as preferring financial institutions that he can bend to his will (see: Fannie Mae and Freddie Mac), and he can be nasty. It would be a disaster if Congress were able to bully banks into pursuing Congress's priorities instead of rebuilding their balance sheets and exiting the program as quickly as possible.

On top of the capital injections, the FDIC announced it will guarantee senior, unsecured bank debt issued between now and June 2009. This will help banks roll over their "trust preferred" debt that would otherwise have no takers as it came due. And while this guarantee is designed to ease the crunch in interbank lending, it is precisely the kind of program that banks can easily get addicted to. Let's hope it really does end next June.

The feds will also offer unlimited insurance on non-interest-bearing commercial deposit accounts, such as those used for payroll runs by businesses. This latter program, for which the FDIC will charge additional premiums, is a far sight better than Mr. Paulson's original brainstorm of guaranteeing all deposits, period.

For those of us who believe in free markets, these interventions are unpleasant. These drastic steps might have been avoided had Treasury and the FDIC acted sooner, yet now they are necessary given the panic that threatens the larger economy. The goal should be to rebuild the financial system so Americans can once again trust their banks enough that government can then recede to its normal supervisory role. We are under no illusions that government will cede its new powers easily, but if it doesn't the economic damage will be far greater than anything we've seen so far.

America was right to look and learn

By John Gapper

History will record that George W. Bush, the US president, faced two big crises during his term of office: the terrorist attacks of September 11 2001 and the financial meltdown of 2008.

Mr Bush’s response to the first was to tell the rest of the world that “you are either with us or against us” and invade Iraq with the UK in tow. His response to the second was to listen to finance ministers from around the world and fall in line with Europe by buying stakes in banks.

I vote for the second approach.

It is much too early to declare “mission accomplished” on the financial crisis since markets remain extremely nervous and banks are still reluctant to lend to one another. But the latest version of the global bail-out plan at least stands a fair chance of success.

Personally, I have more faith in this plan than I did in the Iraq war, partly because the first draft was discussed with others who wanted to achieve the same end. That helped the US to sharpen up its ideas. Designing things by global committee has flaws but launching a unilateral offensive that lacks credibility is worse.

The new tack clearly tickled Jean-Claude Trichet, president of the European Central Bank, at the Economic Club of New York on Tuesday. Mr Trichet, who gave his speech surrounded by financiers and central bankers, including Tim Geithner of the New York Federal Reserve, looked and sounded as if nothing could be more enjoyable than US-European intercourse.

“I am pleased to have exceptionally intimate relations with the Federal Reserve,” he said, singling out “Ben, Don and Tim” for his warmest regards. It sounded like some kind of racy continental ménage à quatre, but he turned out to be talking about financial policy meetings in Basel with Ben Bernanke, Donald Kohn and Mr Geithner of the Fed.

In fact, Mr Bush and Hank Paulson, the Treasury secretary, had to shift positions, despite their resistance to the idea of nationalising banks. The fact that the UK had taken stakes in banks including Royal Bank of Scotland and HBOS, and would be followed by Germany and France, was force majeure.

It was not so much a victory for multilateralism as a recognition that no nation could afford to go it alone in this global crisis. The forces they were all battling – loss of confidence in banks and other institutions and worries over mortgage-related securities – were too big to be tackled by one country on its own.

Mohamed El-Erian, chief executive of the bond asset management group Pimco and winner of this year’s Financial Times-Goldman Sachs Business Book of the Year award, talks of “correlation rather than co-ordination” among the actions of national governments.

Central banks have, pace Mr Trichet, acted in a co-ordinated fashion – their independence from national electorates gives them the freedom to do so. They have not only cut interest rates together but have set up swap arrangements to allow European banks with a mismatch between assets and liabilities to borrow in dollars.

But governments have mostly made do with correlation, also known as watching what others are doing and copying the things that they like. This has been surprisingly effective for a couple of reasons.

First, since we are in uncharted waters, it has let governments try things out in different countries and see how well they work, or go down with investors. The UK bailed out Northern Rock, the mortgage lender, the US guaranteed money market funds, Germany (sort of) stood behind bank deposits, and so on.

Second, it has provided cover for governments that either did not want to take some steps, or faced resistance among electorates to doing so. The best example is the US, where Mr Paulson initially argued strongly against buying stakes in banks as part of his $700bn bail-out plan.

It is difficult to know exactly what he was playing at. Did he initially abhor taking equity in banks as socialist but then change his mind, did he judge that what had been unnecessary had become necessary, or did he always plan to do so?

You can take your pick from his public statements. Last month, he told a Senate committee that “the right way to do this is not going around and injecting capital”. This Tuesday, he reversed himself, with the excuse that his plan was “not what we ever wanted to do” and was “objectionable to most Americans, me included”.

The fact remains that recapitalising banks was the correct course of action all along. The US gets more bang for its buck by doing this, rather than simply trying to entice private capital into banks by supporting the valuations of bad securities.

Mr Paulson, who did after all insert a clause in the bail-out plan allowing himself to switch course, may have been ruled by realpolitik. It was tough enough to get the plan through Capitol Hill without infuriating House Republicans further by raising the spectre of nationalisation.

In a sense, it does not matter what he was up to because he came to the right conclusion with the aid of foreign partners and market forces. Mr Bush and Mr Paulson were forced to accept that they were either with European governments or the markets would be against them.

That goes for European countries too, which could assess Mr Paulson’s initial, flawed version of his $700bn plan before tweaking it. Gordon Brown, the British prime minister, has rightly gained credit for coming up with the best version but he built on what came before.

Call it a victory for common sense, international co-operation, market discipline or what you will. I believe it will achieve more than Mr Bush could have done by himself.

Banks Need Capital, Not Government Management: John M. Berry

Commentary by John M. Berry

Oct. 15 (Bloomberg) -- Once U.K. Prime Minister Gordon Brown decided to recapitalize his nation's banks, other European countries and the U.S. had no choice but to fall in line. That doesn't mean the federal government should try to run the banks that join the $250 billion program.

Participation was hardly optional for the nine large institutions whose chief executives were summoned to a Treasury Department conference room with Secretary Henry Paulson on Oct. 13. In short, the nine -- Citigroup Inc., Goldman Sachs Group Inc., Bank of America, Merrill Lynch & Co., Wells Fargo & Co., JPMorgan Chase & Co., Morgan Stanley, State Street Corp. and Bank of New York Mellon Corp.-- were told that accepting an initial $125 billion in government capital was the patriotic thing to do.

``These are healthy institutions, and they have taken this step for the good of the U.S. economy,'' Paulson said. And now they are supposed to do their duty by using their bigger capital base to expand lending.

That's just what the economy needs, though there's a danger.

In an Oct. 14 editorial, the New York Times said, ``The Treasury should also insist on stepped-up government supervision to ensure that sound lending resumes -- and that reckless lending does not. Government regulators need to frequently review the rescued firms' operations, daily if necessary.''

Is the Treasury supposed to draft a set of rules defining ``reckless lending''? Good luck.

Even in the face of an economic crisis, the last thing anyone should want is a focus on avoiding all risk in making loans. Sound lending always entails some losses, as almost any economist would argue.

Lending Decisions

No government regulator ought to make lending decisions for banks, except in the broadest terms. At the extreme, one could envisage a constituent calling a member of Congress complaining that a bank with government capital was about to cut off his credit line. Or perhaps another constituent complains he can't get a loan for his business and scores of jobs are at stake.

Maybe that's farfetched, or maybe not.

That's not to say there shouldn't be more government supervision. Too little regulation and supervision contributed to the mess the financial system is in, and both need to be tightened regardless of whether taxpayer money is at risk. The broad $700 billion rescue plan, which includes the $250 billion in new capital for banks, includes a requirement that, by the end of April, the Treasury secretary report on the effectiveness of the financial regulatory system and recommendations for changing it.

Getting a Break

Meanwhile, homeowners behind on their mortgage payments are supposed to get a break from banks that get a capital infusion.

``We expect all participating banks to continue and to strengthen their efforts to help struggling homeowners who can afford their homes avoid foreclosure,'' Paulson said in announcing the program.

Another $125 billion of capital is available to other U.S.- controlled institutions until Nov. 14, with the funds to be invested by the end of the year.

The Treasury also is moving ahead with Paulson's original plan to buy troubled mortgage-related assets from banks, as Assistant Secretary for Financial Stability Neel Kashkari explained in an Oct. 13 speech. Many economists have argued the secretary should have focused from the beginning on injecting capital instead of buying assets.

As it turned out, there simply wasn't enough time to get the asset-purchase plan in place once the stock market collapsed and interbank lending and commercial paper issuance all but halted.

Big Enough

Now questions are being raised about whether the plan is big enough.

On a comparable basis, the U.K. is putting twice as much capital into its banks as the U.S. Whether $250 billion will prove to be adequate may depend on the size of banks' losses on bad assets in coming months, particularly now the that U.S. economy looks like it may be headed for a serious recession.

Economist Paul Ashworth of Capital Economics in London told his clients yesterday that he expects those losses to reach an additional $250 billion over the next two years. U.S. financial institutions have recorded more than $380 billion in losses since the crisis began last year.

``The upshot is that all the Treasury will succeed in doing is offsetting future losses and preventing capital adequacy ratios from falling,'' Ashworth said. ``As it stands, we still expect banks to shrink their loan portfolios by roughly 10 percent over the next couple of years, putting more downward pressure on economic activity.''

Doing More

Of course, the government has taken other important steps, and will take more if needed. The Federal Deposit Insurance Corp. is going to guarantee senior debt of all FDIC-insured institutions, and the money in the accounts of most businesses. The Federal Reserve has made unlimited amounts of money available to many foreign central banks in exchange for their local currency and, as of Oct. 27, will begin to buy three-month commercial paper from high-quality issuers.

Democratic congressional leaders are pushing another fiscal stimulus program. Senator John McCain, the Republican presidential candidate, and his Democratic opponent, Senator Barack Obama, have announced their own proposals to spur the economy.

It's all going to be very expensive. Unfortunately, not spending the money would be even more costly to the economy.

Paulson Lacks Leverage to Make Banks Put Cash to Work (Update1)

Oct. 15 (Bloomberg) -- Treasury Secretary Henry Paulson persuaded nine major U.S. banks to accept $125 billion in government investment. Getting them to lend it out may prove a tougher sell.

The equity stakes the government is purchasing in Citigroup Inc., Morgan Stanley and seven other big institutions come with no guarantee that the investments will spur lending and unfreeze credit markets. Nor do they give the government board seats or any other leverage to demand that that the firms actually use the money to help the economy.

``The truth of the matter is, they can't put a gun to their head and say you have to lend this money,'' said Charles Horn, a former official at the Office of the Comptroller of the Currency, part of the Treasury Department, and now a partner at the Mayer Brown law firm in Washington.

Treasury officials acknowledge they can't force banks to get the taxpayer money into the hands of their customers. Instead, officials are betting that the government's investment will create conditions where banks have a greater incentive to earn profits from lending than to hoard money to shore up their balance sheets.

``It's in their economic interest,'' said David Nason, the Treasury's assistant secretary for financial institutions, in an interview with Bloomberg Television. ``When you give them a stronger capital position and you also provide a certain amount of government backstop to their funding sources, it's incumbent upon them to go out and continue to lend.''

Powerful Incentive

Tim Ryan, head of the Securities Industry and Financial Markets Association and a former bank regulator, said the sheer scale of the capital infusion banks are receiving is in itself a powerful incentive to put the funds to work in the economy.

``The bully pulpit doesn't really work with banks, but capital does,'' said Ryan, who directed the U.S. Office of Thrift Supervision in 1990-1992.

The government is providing banks with ``quite a war chest that they were not expecting,'' Ryan said. ``They need to put it to work. The only way you put it to work is to lend.''

The Bush administration's rescue, part of a $700 billion bailout passed by Congress this month, is raising questions about what role the federal government will play as it becomes a leading investor in the financial sector. Already, companies that accept the taxpayer money are required to submit to restrictions on their top executives' pay.

Government Involvement

``Obviously there is a danger'' of increased government involvement in banks' corporate affairs, said Martin Baily, a senior fellow at the Brookings Institution in Washington and former chairman of the Council of Economic Advisers under President Bill Clinton.

Still, Baily said that the equity purchases are set up to minimize government intervention.

Treasury has ``been telling these institutions what to do in the last couple months, so they've exercised a good bit of control,'' Baily added. ``I think they'd like to get out of that business.''

Senator Charles Schumer, a New York Democrat, called on the Treasury to issue guidelines on how banks should use the new funding, saying he's worried institutions may put the extra money into ``exotic financial instruments and experiments'' rather than consumer loans.

Schumer's Concern

``If the capital injections into these institutions help with student loans, help with auto loans, help with small business loans, help with credit card loans, then I think the American people will think this is a worthwhile program,'' Schumer said at a Capitol Hill press conference today. ``On the other hand, if they benefit executives, shareholders or the bank balance sheet, and don't get money churning out into the economy, the program will be regarded as a failure.''

The Bush administration is counting on agencies that already regulate the banks, such as the Federal Reserve, to keep an eye on daily operations. Those agencies can encourage firms to keep credit flowing to businesses and households.

``The regulators can do a lot to give the signals to the bank,'' said finance professor Len Rushfield of Pepperdine University in Los Angeles.

Pressure Has Limits

Even so, subtle government pressure on banks may not make much difference. Unlike with the recent federal takeovers of Fannie Mae, Freddie Mac and insurer American International Group Inc., the U.S. won't take a major share of the banks they invest in. Also, the Treasury has said it won't seek voting rights when it buys stakes.

The Treasury said it would dedicate $250 billion to boost bank capital through preferred stock purchases. Bank regulators estimated yesterday that ``thousands'' of financial companies would participate, although the program will begin with the nine big banks.

``What you'll see most large institutions saying is, `We will certainly listen to the government but our decisions are what's in the best interest of our shareholders,''' said John Coffee, a securities law professor at Columbia University.

Financial companies that accept government investments also are counting on Paulson's pro-market philosophy to keep the government out of their boardrooms. The secretary, announcing the capital injections yesterday, said that he regretted having to make such a move.

Alternative `Unacceptable'

``Government owning a stake in any private U.S. company is objectionable to most Americans -- me included,'' he said. ``Yet the alternative of leaving businesses and consumers without access to financing is totally unacceptable.''

Bank executives know that the Treasury and members of Congress are going to monitor the situation, said Scott Talbott, chief lobbyist for the Financial Services Roundtable.

``Policy makers will watch closely to insure that the money is used for credit,'' he said.

The one unknown that makes Wall Street nervous, several industry executives said, is what the next Treasury secretary will do. The U.S. presidential election is less than a month away.

``You'd probably want to have Hank Paulson, more than a lot of other people'' overseeing the bailout, said Edward Fleischman, a Republican Securities and Exchange Commissioner from 1986 to 1992, and now a senior counsel at the Linklaters law firm in New York. ``But you're not going to have any choice who takes his job.''

U.S. Stocks Plunge Most Since Crash of `87 on Recession Concern

Oct. 15 (Bloomberg) -- U.S. stocks plunged the most since the crash of 1987, hammered by the biggest drop in retail sales in three years and growing doubt that plans to bail out banks will keep the economic slump from deepening.

Exxon Mobil Corp. and Chevron Corp. tumbled more than 12 percent as commodity prices declined on concern the slowing economy will hurt demand. Wal-Mart Stores Inc. retreated 8 percent after the Commerce Department said purchases at chain stores decreased 1.2 percent last month. Morgan Stanley lost 16 percent after Oppenheimer & Co. analyst Meredith Whitney said the government's bank rescue is not a ``panacea'' solution.

The Standard & Poor's 500 Index sank 90.17 points, or 9 percent, to 907.84, with nine companies declining more than 20 percent. The Dow Jones Industrial Average retreated 733.08, or 7.9 percent, to 8,577.91, its second-biggest point drop ever. The Nasdaq Composite Index lost 150.68, or 8.5 percent, to 1,628.33. About 37 stocks fell for each that rose on the New York Stock Exchange.

``It's absolutely trading on fear right now and uncertainty, because nobody knows yet how bad the economy is going to get,'' said John Wilson, the co-director of equity strategy at Memphis, Tennessee-based Morgan Keegan, which manages $120 billion. ``It's disquieting to me, and I've been doing this for 35 years.''

Rally Pared

The retreat over the past two days erased almost all of the gains in the S&P 500 and Dow on Oct. 13, when the market rallied the most since the 1930s on speculation the government's plan to shore up banks will ease the credit crisis. Efforts to calm financial markets probably won't result in an immediate economic rebound, Federal Reserve Chairman Ben S. Bernanke told the Economic Club of New York.

All 10 S&P 500 industries fell more than 6 percent today. About $1.1 trillion in value was erased from all U.S. equities. The declines came after the drop in retail sales was almost twice economists' estimates, sending Macy's Inc. and Dillard's Inc. down more than 15 percent. The Federal Reserve's index of New York manufacturing slumped to minus-24.6, a record low. The data overshadowed a retreat in money-market rates and better- than-estimated earnings reports from JPMorgan Chase & Co., Coca- Cola Co. and Intel Corp.

``A big chunk of our economy is in recession right now,'' said Tom Wirth, senior investment officer at Chemung Canal Trust Co. in Elmira, New York, which manages $1.5 billion. ``There's fear the Christmas season is going to be miserable.''

VIX Jumps

The VIX, as the Chicago Board Options Exchange Volatility Index is known, jumped 26 percent to 69.25 for the biggest gain in three weeks. The measure, known as Wall Street's ``fear gauge,'' has tripled since the beginning of September.

About 1.7 billion shares changed hands on the floor of the NYSE. The value of shares traded on the Big Board was $43.3 billion, the lowest since Oct. 3.

The S&P 500 lost more points on Sept. 29 when it fell 106.62, while its percentage decline of 8.8 percent was less than today's tumble.

Stocks in Europe and Asia fell for the first time in three days, helping push the MSCI World Index, a benchmark for 23 developed countries, to a 7.3 percent decline. Brazilian stock trading was briefly halted after the Bovespa index plunged 10 percent. The index closed down 13 percent after trading resumed.

Exxon Mobil, Chevron and ConocoPhillips, the three biggest U.S. oil companies, helped lead energy companies to the biggest retreat among 10 S&P 500 industries as crude fell below $75 a barrel for the first time in more than a year. The Organization of Petroleum Exporting Countries cut its 2009 demand forecast for a second month.

The S&P 500 Energy Index, once the year's best performing industry group, retreated 15 percent today for its steepest lost since the gauge was created in 1989. It is down 49 percent from its peak in May.

Whitney's Call

Citigroup Inc. fell $2.39, 13 percent, to $16.23 and Morgan Stanley slid $3.54 to $18.13 after Oppenheimer's Whitney said the capital infusions from the Treasury are ``one large step in the right direction,'' though not a ``panacea.''

``We are at least several quarters away from stabilizing fundamentals,'' Whitney wrote in a note dated yesterday. ``Credit costs will continue to surprise on the upside and revenues will begin to surprise on the downside as companies will be forced to make money off of lower asset bases.''

Visa Inc., MasterCard Inc. and American Express Co. had declines greater than 11 percent on concern consumers will charge less during the holiday season.

JPMorgan Erases Gain

JPMorgan erased earlier gains and fell 5.5 percent to $38.49 even after the largest U.S. bank by market value reported quarterly earnings that beat analysts' estimates. The company will set aside more money to cover loan losses as the lender braces for the economic slump to get ``a lot worse,'' Chief Executive Officer Jamie Dimon said.

Jones Apparel Group Inc. lost 30 percent to $9.51, the biggest drop in the S&P 500. The maker of Jones New York clothing and Nine West shoes forecast profit lower than its previous projection and S&P strongly recommended selling the stock.

Dell Inc. dropped 11 percent to $12.58. The world's second- largest personal-computer maker was cut to ``neutral'' from overweight by JPMorgan analyst Mark Moskowitz. The company gets about 60 percent of revenue from personal computers, which is a ``hurdle to achieving consistent growth,'' the analyst said.

EBay Inc. retreated 14 percent to $15.33. The largest Internet auction company was cut to ``underperform'' at Merrill Lynch & Co., which said it doesn't expect ``positive'' third- quarter results or fourth-quarter forecast. EBay reports earnings after the official close of U.S. exchanges today.

Coke Gains

Coca-Cola Co. climbed 1.1 percent to $44.21 for the only advance in the Dow average. The world's largest soft-drink maker posted third-quarter per-share profit that exceeded analysts' estimates by 8.1 percent on increased sales outside the U.S.

Genentech Inc. added 3 percent to $81.50. The largest U.S. maker of cancer drugs said third-quarter profit rose 6.7 percent as sales of tumor-fighting medicines beat analysts' estimates.

The S&P 500 fell yesterday as a worsening earnings outlook at PepsiCo Inc. and Microsoft Corp. overshadowed the $2 trillion global push to rescue the financial system. The U.S. is in a recession and the Fed's interest-rate stance is aimed at addressing the risks of a deeper slump, according to San Francisco Federal Reserve President Janet Yellen.

`Heavy Toll'

The economy deteriorated throughout the U.S. last month and pessimism about the outlook spread, the Federal Reserve said in its regional economic survey. Retailing, auto sales and tourism declined in ``most'' districts, while housing and construction ``weakened or remained low,'' according to the Beige Book report, published two weeks before officials meet to set interest rates.

Confidence in the global economy plunged in October after a deepening freeze in financial markets increased the chances of a recession, a survey of Bloomberg users on six continents showed. The Bloomberg Professional Global Confidence Index fell to 4 from 11.3 in September, the lowest since the survey began in November.

The latest chapter in the credit crisis came when Lehman Brothers Holdings Inc. filed the biggest bankruptcy in history on Sept. 15. The company's hedge-fund clients are now largely unable to access their Lehman accounts even as the value of the securities continues to fluctuate along with the markets.

Margin Calls

The investors may be required to put up more collateral if the value of those securities drops, a process known as a margin call, according to Steven Pearson, the partner at PricewaterhouseCoopers responsible for unraveling Lehman's U.K. operations.

Goldman Sachs Group Inc.'s Hedge Fund VIP Basket, an index of stocks with the most hedge-fund ownership, slumped 12 percent today.

Dollar money-market rates fell after the European Central Bank, Bank of England and Swiss National Bank offered lenders unlimited U.S. currency for the first time in a coordinated effort to unlock credit markets. Three-month dollar Libor slid 0.09 point to 4.55 percent.

BHP Billiton Ltd., the world's largest mining company, and Xstrata Plc, the fourth-biggest copper producer, lost more than 14 percent as copper, lead, tin and nickel prices slid on the London Metals Exchange. Posco, Asia's third-largest steelmaker, retreated 8.5 percent.

`Slowing Hard'

``The rest of the world is slowing and slowing hard, and so that translates to basically being underweight the global cyclicals, which is energy and materials,'' Binky Chadha, the New York-based chief U.S. equity strategist at Deutsche Bank AG, said on Bloomberg Radio.

Merrill Lynch & Co., Honeywell International Inc., Citigroup Inc. and Google Inc. are among the S&P 500 companies slated to release earnings this week.

The S&P 500 has tumbled 38 percent in 2008 as losses and writedowns from mortgage-related investments at financial firms worldwide topped $640 billion. The U.S. stock benchmark is valued at 11 times estimated 2008 profit for its companies. When that price-to-earnings ratio sank to 10.9 on Oct. 10, the index was the cheapest compared with the multiple using trailing profit since June 1985.

The S&P 500 has tumbled 42 percent from its Oct. 9, 2007, record and the Dow has lost 39 percent from its peak the same day.

``I'm pretty sure that if I go all in right now, I'll be better off in the next six months, but boy, I'll lose some sleep,'' said Morgan Keegan's Wilson. ``There's always that little nagging voice that says, `What if it's different this time?'''

Governments have at last thrown the world a lifeline

By Martin Wolf

In the last week the world has seen the UK’s “good Gordon” in action. Confronted by the implosion of the country’s financial system, Gordon Brown, the British prime minister, acted. The plan his government came up with is comprehensive and bold. It will also be expensive. But the cost will be much less than the alternative – a depression – would have been.

More important, others now agree. The meetings of financial policymakers in Washington over the weekend bore fruit, first in a general communiqué and then in detailed programmes of action. The European agreement is particularly impressive. Mr Brown can rightly claim to have been the leader. The world has, as a result, stepped away from an abyss, though the road ahead remains strewn with obstacles.

Policymakers finally realised that a plan for dealing with such a severe financial crisis must contain those elements that are individually necessary and collectively sufficient. Two elements are necessary: massive provision of liquidity and recapitalisation of financially weak institutions. Two other elements will help, dependent on the circumstances: guarantees to lenders and purchases of defective assets. The US, with its complex financial system and bad mortgage assets, will find blanket guarantees hard to manage but may benefit from purchases. Europeans seem to be in the opposite situation.

The announced programmes are, in scale and construction, what is needed. Difficulties will arise in containing the distorting effects of the guarantees and arranging an exit from a partially nationalised system into one better regulated than before. But the announcements made this week, not least in the US, epicentre of the storm, should abate the panic.*

The US Treasury’s programme is, at last, suitably comprehensive. The European announcements, with promises to spend more than €1,873bn ($2,544bn, £1,479bn) are also impressive. Meanwhile, the UK has already invested £37bn in three of the country’s biggest banks.

These are extraordinary actions for extraordinary times. But will they work? Two risks remain: first, worry may shift from the creditworthiness of banks to that of governments; second, economies may weaken far more profoundly than policymakers believe. These risks are real, but containable.

Can governments afford the money they are about to spend? Yes, is my answer. Indeed, governments should be able to get all the money they are now laying out back from their banking industry. Assume the economies have a future. If so, core banking franchises will make money, as they have in the past. If banks can make money, they can repay. The task is merely one of designing the support to ensure they do.

The question of affordability is, therefore, one of fiscal credibility: if markets became sufficiently worried about the outlays, particularly at a time of large fiscal deficits, the impact on interest and exchange rates might make a default – either via inflation or even more directly – conceivable. But this still seems extremely unlikely.

In its new Global Financial Stability Report, the International Monetary Fund re-estimates losses on US loans at $425bn and mark-to-market losses on US mortgage, consumer and corporate debt at $980bn, for a total $1,405bn, up from $945bn last April (see chart). How much of this will be realised is unknown. It could be substantially less. If the economy went into a deep recession, however, it could be considerably more. But, at this point, this is “only” 10 per cent of US gross domestic product.

This is not by any means extraordinary for a big financial crisis. Moreover, close to half of these losses will fall outside the US (the joys of risk diversification!). So the total losses are now “only” 5 per cent of combined US and European GDP. A part, moreover, of the total has already been made good, by raising about $430bn in additional capital (on what mostly turned out to be catastrophic terms for shareholders).

Against this, four concerns must be registered: first, additional losses are likely on already contracted domestic European mortgage debt and as a result of the economic slowdown under way; second, countries with exceptionally large banking systems and exceptionally high domestic indebtedness may find fiscal burdens far heavier; third, the banking sector also needs extra capital, to offset the collapse of the so-called “shadow” banking sector; and, finally, the sector also needs to be substantially better capitalised.

Informed observers suggest an additional $1,500bn in capital might be needed for such reasons. So double this and assume it all comes from the state: it would still “only” be 10 per cent of US and European GDP. If the real interest rate were 2 per cent, this would be a permanent increase in public spending of 0.2 per cent of GDP. Moreover, this would not be extra demand for resources. It would be a recognition of past errors: a part of what people thought was private lending turned out to be public spending. Stuff indeed happens!

Nearly all western governments ought to be able to get away with what they are doing. But some help might have to go to weak neighbours, notably in central and eastern Europe.

Whether this relative optimism proves justified also depends on the severity of the recession. In its latest World Economic Outlook, the IMF could best be described as concerned but not apocalyptic: advanced economies are forecast to grow by 0.5 per cent in 2009, with the US on 0.1 per cent and the eurozone on 0.2 per cent; and emerging economies are forecast to grow 6.1 per cent next year, with developing Asia on 7.7 per cent. Overall, world output, at market exchange rates, is forecast to grow at 1.9 per cent in 2009, down from 2.7 per cent in 2008 and 3.7 per cent in 2007.

It is easy to tell a far worse story, with further collapses in asset prices shattering confidence and so generating big cutbacks in consumption and investment. But it is also easy to tell a better story: weakening commodity prices free central banks to pursue aggressive monetary policies, accelerating the recapitalisation of the banks, helping sustain credit and so minimising the chances of a big overshoot in asset prices on their necessary way down.

Western governments have decided to throw all their vast resources at their damaged financial sectors. A great deal of pain will still come. At some point partial nationalisation of finance must also be replaced by privatisation and better regulation. But the tide in this crisis has turned.