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08-10-2007, 07:56 AM
Global markets tumble, with Dow losing 387 points
A major French bank's troubles with sub-prime loans reverberate through Europe, Asia. Dow, other gauges dive.


By Tom Petruno and Peter G. Gosselin, Los Angeles Times Staff Writers
August 10, 2007

The U.S. sub-prime mortgage crisis shook the world's financial system Thursday, unnerving bankers and investors and raising the risks for the global economy.

Markets worldwide staggered after a big French bank sparked a financial scare by halting withdrawals from investment funds that have lost money on high-risk U.S. mortgage securities.

The news suddenly made skittish European banks reluctant to lend to one another on the usual terms. The central banks of major economies, including the United States, responded by pumping tens of billions of dollars into their banking systems in an effort to shore up investors' confidence.

But stock markets on both sides of the Atlantic tumbled anyway. On Wall Street, the Dow Jones industrial average plunged 387.18 points, or 2.8%, to 13,270.68, its largest one-day loss since February. Early today in Asia, stocks were down sharply as well.

The day's events were the latest shock in the ongoing tumult stemming from the woes of struggling U.S. homeowners. The housing market's troubles -- and the risk they pose to the economy -- have helped drive stock markets down sharply in recent weeks, amid extraordinary volatility.

At the heart of global markets' turmoil is the financing that fueled the unprecedented U.S. housing boom of this decade. The rise of sub-prime loans -- mortgages for people of limited means or whose credit was dicey -- allowed millions of Americans to buy or refinance homes.

Wall Street funded many of those loans by packaging them into complex bonds designed to pass homeowners' loan payments through to investors.

But as growing numbers of homeowners have found they can't make their payments, sub-prime bonds have plunged in value. And because the securities were so popular with investors around the globe, every day seems to bring fresh reports of heavy losses.

"There's little knowledge about who holds the toxic waste and how much they hold," said Paul Kasriel, an economist at Northern Trust. "We see these dead fish float to the surface every now and then, and it's happening more frequently. That creates concern about where some of the other dead fish may be stored. No one knows."

For the economy, one escalating fear is that the upheaval in financial markets could damage the confidence of consumers, leading them to rein in their spending and spurring a deeper downshift in the pace of growth.

On Thursday, major U.S. retailers reported disappointing July sales, adding to concerns about the economy's near-term outlook.

The fuse for Thursday's market blow-up was lighted in Paris, where BNP Paribas, the largest French bank, barred big investors from pulling their money out of three funds managed by the bank.

BNP said the market for certain securities the funds owned, including sub-prime bonds, had become so frozen with fear that fund managers couldn't place a value on the securities.

Europe's financial system was jolted by BNP's move. Short-term interest rates jumped, reflecting banks' nervousness about lending to one another.

That spurred the European Central Bank to take dramatic action. It poured $130 billion into the continent's banking system in an attempt to pull rates back down. The sum was far more than the burst of assistance the bank provided after the Sept. 11, 2001, terrorist attacks in the U.S.

The Federal Reserve also sought to calm frightened markets by adding money to the U.S. banking system but on a much smaller scale.

Lou Crandall, an economist at investment firm Wrightson ICAP in Jersey City, N.J., said the central banks "were essentially acting as the lender of last resort" to keep financial markets from seizing up, which in the worst-case scenario could turn into a cascade of banks, brokerages and other financial companies being unable to pay what they owe one another.

Stock markets around the globe, reeling for weeks on worries about spreading credit problems, suffered another sharp decline as fearful investors fled. Major European stock markets tumbled about 2%.

The U.S. Dow Jones index, which had rebounded 475 points the previous three days, gave back all but one-fifth of that advance Thursday.

"People are getting away from risk in every way they can," said Christopher Sheldon, director of investment strategy at Mellon Private Wealth Management in Boston.

But U.S. policymakers sought to downplay the markets' latest plunge and the danger to the economy.

Although the Federal Reserve injected an extra $24 billion in temporary reserves into the banking system after short-term interest rates climbed above the Fed's target rate of 5.25%, many analysts said that was a muted response.

And after meeting with Treasury Secretary Henry M. Paulson Jr., President Bush went before the cameras for a second day to say that the U.S. economy was strong and credit was plentiful.

Asked about recent market volatility, Bush replied, "I am told there is enough liquidity in the system to enable markets to correct," a clear indication that the government wants to see the markets solve their own troubles, analysts said.

For months, many Bush administration and Federal Reserve officials have insisted that tumult in the housing and mortgage markets wasn't significantly affecting the domestic economy, which they said was in solid shape overall.

Fed officials met Tuesday and held their key interest rate steady for a 14th consecutive month, declaring that despite volatility in markets and an ongoing decline in the housing sector, "the economy seems likely to continue to expand at a moderate pace over coming quarters."

The Fed walks a fine line in handling financial market disruptions. On one hand, the central bank doesn't want to step in to solve problems for investors who have made bad decisions, such as by loading up on high-risk bonds.

"Capitalism without failure is like religion without sin," said longtime Fed watcher Allan Meltzer, a professor at Carnegie Mellon University in Pittsburgh. "The only way for people to learn not to do foolish things is to allow them to be penalized."

On the other hand, the Fed can't allow problems to get so severe that they threaten the nation's credit system, and thus the economy itself.

Many analysts say the Fed has no reason to hint that it might begin cutting interest rates unless stock prices go into a tailspin and the economic expansion appears to be in jeopardy.

Michael Darda, chief economist at MKM Partners in Greenwich, Conn., said there was still little evidence that the troubles in the credit and stock markets were spilling into the real economy.

"Intervention now would be the height of irresponsibility," Darda said. "The Fed has done a good job of holding the line."

But Mark Zandi, chief economist of Moody's Economy.com, contended that banks and investors were increasingly fearful about the dimensions of the housing and mortgage troubles, making them less willing to lend. That could slow the economy down, he said.

"We're very close to needing a much more aggressive response to the problem from the Fed," he said.

Some experts, however, criticized the European Central Bank's decision to pump such a large sum into the banking system Thursday, saying it may have fostered panic by causing investors to question whether things were worse than they'd imagined.

"If you're a central banker, you're supposed to act like you know what you're doing," said an economist at a major brokerage, who asked that his name not be used because his firm deals with central banks.

In recent weeks, a lengthening list of big investors have disclosed heavy losses in mortgage securities.

Bear Stearns Cos., one of the nation's premier brokerages, said two investment funds that it managed had become nearly worthless because of mounting losses on mortgage bonds.

More recently, a German savings bank failed because of losses tied to such bonds, and several investment funds in Australia said they were being dragged down by similar securities.

As investors have balked at buying mortgage securities, they also have fled other high-risk bonds, such as those used to finance corporate buyouts. That, too, has undercut the stock market because the buyout wave had helped drive up share prices.

In recent months, the phrase that Wall Street, Treasury and Federal Reserve officials had been using about the sub-prime mess was that it was "well contained," meaning that it wasn't spreading.

Now, "The more these guys say it's 'well-contained,' the more you know it's not," said Jim Keegan, a bond fund manager at American Century Investments in Kansas City, Mo.