Surprise Rejection of Bailout Deal Causes Record Decline in U.S. Stocks, Paves the Way for a Better Accord

By William Patalon III,
Jennifer Yousfi and Jason Simpkins
Money Morning Editors

In a move that will reverberate from Wall Street to Main Street, the U.S. House of Representatives yesterday (Monday) voted to reject a compromise $700 billion banking-bailout bill, an act of stunning defiance that eradicated $1.2 trillion in shareholder wealth as U.S. stocks endured their biggest one-day point loss in history.

The blue-chip Dow Jones Industrial Average Index plunged 777.68 points, or 6.98%, to close at 10,365.45. The tech-laden Nasdaq Composite Index plummeted 199.61 points, or 9.14%, to close at 1,983.73. And the broader Standard & Poor's 500 Index plunged 106.59 points, or 8.79%, to finish the day at 1,106.42.

All sectors were gutted, but energy and financials were among the hardest hit, plummeting 11.02% and 10.55%, respectively.

"My outrage over this just continues to grow," Money Morning Investment Director Keith Fitz-Gerald said in an interview late yesterday. "This just didn't have to happen."

U.S. share prices sold off sharply once it appeared the House measure would go down to defeat and continued to slump as the afternoon progressed when that appearance became a reality.

Financial markets worldwide had slumped even before the House voting began; Hong Kong's blue-chip Hang Seng Index plunged 4.3%, while the Paris-based CAC40, London's FTSE 100 and in Paris and London they were down 3 percent. Hong Kong's blue-chip Hang Seng Index plunged 4.3%, nose-diving 801.41 points to close at 17,880.70.

By 3:15 p.m. EDT, the Dow had fallen more than 5%. House leaders backing the bailout deal kept the voting period open for more than 40 minutes past the allotted time, pointing to the damage being done to the U.S. stock indices in an effort to convert some of the "No" votes to votes of approval - to no avail, The New York Times reported.

There may have been some optimism - reflected by the close of markets on Friday - that that whatever deal might come out of the Congressional-compromise efforts being hammered out over the weekend would be better than what had previously been on the table, said R. Shah Gilani, a former hedge fund manager who is now a Money Morning contributing editor, and who last week crafted an alternate bailout plan that he presented to readers of this global investment news service. Then, when markets overseas saw what was actually forthcoming, the markets in Asia and Europe sold off as a way of effectively voting "No" to the bailout plan. When the U.S. markets fell at the open, it was as if investors were telegraphing that the deal was doomed, Gilani said.

"What the markets reflected was a 'no-confidence' vote in the rescue plan - period," Gilani said. "When the House [of Representatives] vote finally came in, the resulting deeper drop evidenced despair in the continuing politicization and shotgun to specific problems that, for all clear minds, can readily be neutralized by targeted action. Either way, this was never going to be a positive day for the markets."

The vote against the measure was 228 to 205, with 133 Republicans joining 95 Democrats in opposition to a legislative measure that President George W. Bush and Congressional leaders of both parties claim is crucial if the country is to avert a total meltdown of the U.S. financial system. The bill was backed by 140 Democrats and 65 Republicans, The New York Times reported.
Proponents of the bailout bill promised to do their best to bring another rescue plan up for consideration in as short a period as possible - perhaps as soon as tomorrow (Wednesday) or Thursday, although there were no plans to do so as of yesterday evening.

"It's pretty much a nightmare," Michael Nasto, the senior trader at U.S. Global Investors Inc. (GROW), told Bloomberg News. "This is the worst we've seen it since the credit mess started. Until we know exactly why they didn't pass it, we're going to be selling off for a while."

The CBOE Volatility Index, or VIX index, hit a record high of 46.72 yesterday. The VIX is a measure of "investor sentiment and market volatility." Using real time options prices, it is often used as a measure of fear in the market. The higher the VIX goes, the more fear in the market as investors utilize options to hedge positions.

Given the panic unfolding on Wall Street yesterday, a high VIX reading doesn't seem that surprising. But what is surprising is that historically, the S&P 500 Index has performed well after such high fear-fueled days.

"Since 1990 there have been four other periods where the VIX closed above 40," Bespoke Investment Group said in a research report released yesterday. "Following each period, the S&P 500's performance was mixed the next day and week, but over the following month and quarter, the S&P 500 has had consistently positive returns."

Commodity Markets

Commodity results were mixed as the equity crash had opposite effects on oil and gold.

Concern that the weakening economy would severely hamper demand sent oil futures diving. Crude oil for November delivery dropped $10.52, a decline of 9.8%, to close at $96.37 per barrel on the New York Mercantile Exchange. It was the second-largest one-day drop in dollar terms, according to FactSet Research data.

Meanwhile, investors seeking a safe place to invest went running for the yellow metal. Gold for December delivery gained $5.90, or 0.7%, to close at $894.40 per ounce on the Comex division of the New York Mercantile Exchange, MarketWatch reported.

"It would be hard to invent a scenario that could be more bullish for gold than right now," Mark O'Byrne, executive director at Gold and Silver Investment, told MarketWatch. "Bailout or no bailout, gold is going a lot higher due to a broad based flight to quality."

In the bond market, yields on both the 10-year and 2-year U.S. Treasury notes fell as investors poured funds into the safer Treasury Market in yet another example of the current flight to quality. 

Central Bank Moves

But even as the Treasury yields were falling, the London Interbank Offered Rate, or LIBOR, was on the rise to almost 4%, as banks' risk aversion kicked up another notch and financial institutions demanded a premium for lending under the current market conditions.

Global central banks included the U.S. Federal Reserve and European Central Bank flooded the markets with hundreds of billions in short-term funds in hopes of restoring confidence to the short-term credit markets. The central banks have been making similar moves for months, boosting liquidity in hopes that the credit markets will return to normal.

"Are the problems so bad that they have to keep doing [this]? Is this just not working? These questions are not mutually exclusive," Art Hogan, chief market strategist at Jefferies told Forbes. "The fact is the banks don't trust each other, and a greater confidence level is needed to get banks to start working with each other."

The Fed increased its existing currency swaps to $620 billion from $330 billion in an effort to make dollars more available worldwide.

"These steps are being undertaken to mitigate pressures evident in the term funding markets both in the United States and abroad," the accompanying Fed statement read. "By committing to provide a very large quantity of term funding, the Federal Reserve actions should reassure financial market participants that financing will be available against good collateral, lessening concerns about funding and rollover risk."  

Looking Ahead

Ever since it became clear that the U.S. government's decision to take control of foundering mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) was driven not by worries about the fading U.S. housing market, but by concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds, it was just as clear that the credit crisis was no longer just a domestic affair [For the full story on the U.S. government's decision to take control of Fannie Mae and Freddie Mac, check out this special Money Morning investigative report.]

The global implications of the credit crisis were demonstrated again yesterday with the early-day sell-offs in Asia and Europe. And it will likely be underscored again early today (Tuesday), after those overseas markets continue the record sell-off that took place yesterday on Wall Street.

Bailout-bill backers also will head back to the drawing board. And that's not a bad thing, Money Morning's Gilani said. Indeed, he believes lawmakers should craft a new plan, and then let the market decide if it's valid or not since "there is no better way to test a new plan than to subject it to market reaction - period."

"There is exceptionally good news in this turn of events," Gilani said. "With the stench of politics and partisan airs out of the room, now, a better plan can be presented. There's no reason why a new plan cannot be on the table tomorrow morning, vetted openly to the markets by Thursday and presented for a vote by Friday. The open vetting process will be reflected in the markets on an ongoing basis. What we're trying to do here is calm and ultimately "fix" the markets. We need to listen to them respond to the medicine we are presenting."

And since there's no actual "plan" out there at the moment, Gilani says investors should once again look at "The Money Morning Plan" that he crafted an unveiled last week.

"My 'Money Morning Plan' is the only plan that immediately can be vetted, openly and transparently, because it is not a political, partisan nor finger-pointing exercise," Gilani said. "It is simple, easy to enact, easy to monitor, flexible, and the only plan currently circulating, in the world, that addresses the actual triad of culprits: the problem securities themselves; the credit default swap market; and relief for homeowners and taxpayers."

[Editor's Note: Money Morning Contributing Editor and credit expert Shah Gilani has outlined an alternative bailout plan that is designed to ease the banking crisis at a minimum cost for U.S. taxpayers. It's a complicated issue, no doubt. But we urge you to take a look at the "Money Morning Plan." If you believe that some (or all) of these points make sense, we urge you to make it your plan: Pass "The Money Morning Plan" along to the congressional representatives and governors of your respective states - especially now that the debate has taken on an emergency status and that time is of the essence. We've even provided a listing of each state's representatives to help you pass this plan along. In the meantime, Money Morning is looking for profit opportunities beyond U.S. borders: For instance, check out this new report on a Wisconsin-based company we've discovered that's posting quarter after quarter of earnings surprises - while the rest of Wall Street tanks. Not only does this company have a lock on China - the fastest-growing market on the planet - this corporate gem is also riding the profit wave of the most-powerful global trend that we're following right now. If you act on this opportunity now - as an added bonus - you'll also receive a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, " Crash Proof: How to Profit from the Coming Economic Collapse."]

News and Related Story Links:

  • Forbes:
    Fed Opens the Spigots

About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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