Fear Drives Wild Trading Ahead Of G-7 Meeting

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After a string of firsts for the world's financial markets, it seemed fitting that the week ended with the Dow Jones industrial index making more history: For the first time ever, it traded in a 1,000-point range.

The Dow ended the day down 128 points to close at 8,451.19.

Investors have been snatching at straws. On Friday a late-day bounce came after the markets convinced themselves that this weekend's Group of Seven meeting will bring some sort of coordinated move to unfreeze the global credit markets.

Finance officials from the world's top economic powers emerged from talks Friday with a five-point plan to reverse the credit crisis, vowing "decisive action" and pledging to "use all available tools."

Investors are hoping the central banks or perhaps the International Monetary Fund will guarantee interbank lending so that the credit markets can get moving again.

Investors around the world have spent the past couple of weeks pinned between frozen credit markets and policymakers struggling to thaw it. They have been selling stocks on the concern that the month-old financial crisis won't just hobble banks and financial institutions but instead will drive the global economy into a deep recession.

'Urgent And Exceptional'

"The current situation calls for urgent and exceptional action," the G-7 finance ministers said in a joint statement. They did not provide specifics.

"The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on the countries," the finance officials said.

U.S. Set To Buy Bank Stock

U.S. Treasury Secretary Henry Paulson said the Bush administration will proceed with a plan to buy stock in financial institutions — a first since the Great Depression. But he said the purchases would be of nonvoting shares, meaning the government will not take a role in running the companies.

"As we develop plans to purchase equity ... we are working to develop a standardized program that is open to a broad array of financial institutions," Paulson said in a statement.

Paulson said the government's program would be designed to complement the efforts of banks to raise fresh capital from private sources.

Markets Running On Emotions

For days now, the markets had been running on emotion. Investors are no longer buying or selling based on fundamentals. Instead, the motivator has been fear: fear of more bank failures, fear of a global recession, and fear that there is nothing that policymakers can do to stop the world economy from slipping into the abyss.

Of course, if a grand plan does not come out of this weekend's G-7 meeting or even by Monday, that could take some of the air out of the market. And the roller coaster ride could begin anew.

Details On Lehman Brothers Credit Default Swaps

Friday afternoon, the financial institutions that provided default insurance on the now-bankrupt Lehman Brothers found out how much they will have to pay to make the buyers whole.

At an auction held Friday, the price for Lehman debt was set at 8.625 cents for every dollar. That means that any company that sold swaps tied to Lehman debt will have to pay out the remaining 91.375 cents for every dollar on the contract.

The pricing sets up the biggest-ever payout in the $55 trillion credit default market.

Because there is no central exchange or system for reporting credit default swap trades, analysts have been fretting over the lack of transparency and uncertainty that these financial instruments inject into the credit markets.

Among the many factors holding up lending was the question of just how much credit default swaps will be worth. Now that banks have some clarity on the Lehman swap price, it could give them a better picture of their own financial health — and the health of those they lend to.

The downside is that the Lehman credit swap price could add more volatility to the stock market. The theory is that if institutions have been selling stock to raise money in anticipation of settling those swaps, then they might put the money back into the market now that the value of the swap is clearer.

Credit Remains Tight

Hedge funds, insurance companies and banks buy and sell credit protection as a matter of course. They have used credit default swaps as a hedge to insure a bond against a default or, in some cases, as a bet against a company's ability to pay off its debt.

Credit swaps are part of the reason the credit markets are drum tight right now. It is very expensive to borrow money — if you can get it at all — because banks still don't feel confident enough to lend money.

The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, proves the point. It widened to 4.62 percentage points on Friday, according to Bloomberg figures. That is the biggest spread since Bloomberg began compiling data in 1984. To give an idea of just how much the financial crisis has affected credit, the TED spread was 1.16 percentage points a month ago.

President Bush appeared in the Rose Garden soon after the market opened Friday, seeking to calm investors. He said his administration was working to stem the crisis, but it would take some time for the measures to take hold. "We are a prosperous nation with immense resources and a wide range of tools at our disposal," the president said after providing a list of the measures his administration has already put in place. "We can solve this crisis and we will."

Today's sell-off in the stock market isn't about fundamentals — such as corporate earnings and dividends; instead, it is all about emotion. People are selling because they are scared. Typically, when emotion is motivating sales, it means the market is getting close to a bottom.

"People are still in panic mode," Art Hogan, a managing director at Jefferies, told CNBC. "The bottom gets put in today. You heard it here: Today is going to be the bottom."

Boosting Confidence, Or Rattling Investors?

What may be most remarkable is that the weeklong sell-off has happened in spite of a number of high-profile moves aimed at building investor confidence.

Early in the week, the Treasury announced that it would give credit markets a boost by buying short-term loans known as commercial paper. Businesses buy commercial paper to help with cash flow — they are like short-term IOUs that allow them to pay for raw materials or for payroll. The Fed went into the market because banks are loath to lend anyone money right now. The move, while welcome, did little to thaw credit markets.

On Wednesday, the Fed announced that it was joining with five other central banks around the world to slash key interest rates by a half-percentage point. The thought was that making borrowing cheaper would free up credit. It didn't work.

Instead, the rate cuts only seemed to rattle investors more. Investors were torn between viewing the unusual coordinated move as an indication that central banks are prepared to do whatever it takes to prevent a global recession — or as a sign that something even more awful is coming down the pike.

Thursday morning, U.S. investors woke to the news that the Treasury Department was considering taking ownership stakes in U.S. banks. NPR reported last week that Treasury Secretary Henry Paulson was weighing a plan in which the U.S. government would directly inject cash into struggling firms in exchange for an ownership share. The money to do that would be taken from the $700 billion financial rescue package that Congress passed and President Bush signed last week.

Many economists have said a cash-injection plan would be a better way to address the financial crisis than just taking distressed assets off banks' books at fire sale prices.

"These capital injections are something that Secretary Paulson is actively considering," said White House spokeswoman Dana Perino at a press conference Thursday.

Is AIG A Harbinger?

Among the factors driving the market is an irrational fear of the unknown.

Investors are worried that they are only seeing the tip of the iceberg, and that financial institutions are hiding more scary news beneath the surface.

That has become a self-fulfilling prophecy.

In some ways, insurance giant AIG has become a harbinger of that fear. The New York Fed announced Thursday night that AIG has already burned through $70.3 billion of the $85 billion the Fed lent it just three weeks ago.

The rate at which AIG is gobbling up money is part of the reason the Fed decided to extend a second loan of nearly $38 billion to the company this week. The burn rate of cash at AIG has raised the question of just how deep a hole AIG — and other financial institutions — are in.

"I think you are going to find that the problems are deeper than the initial estimate," said John Coffee, a securities law expert at Columbia University. "There is always a tendency to underestimate your problems. Once you find the government is in for $85 billion, you may recognize that the government can't stop there. They have got to save you, and it may be another X billion will still be required."

The Fed clearly ran into that issue this week when it announced that it would be lending AIG as much as another $37.8 billion. Nick Ashooh, a spokesman for AIG, said that people shouldn't jump to the conclusion that the $85 billion lending facility the Fed gave the company isn't enough.

"Actually, under this new program, the hope is it will reduce our need to access the $85 billion facility," he said. "It gives us relief on the cash-flow front, which is what the $85 billion is there to do."

Some investors see the second loan as sending a different message. They worry that if the Fed underestimated the scope of AIG's problems, perhaps the government also undershot the mark with its $700 billion bailout package for the financial industry more generally.

"I would say the market reaction for the last couple of days shows the market judgment is that the $700 billion may be well short of what is necessary," said Coffee.

But it's important to remember that even if the government ends up spending more than $700 billion, it won't necessarily be a dead loss. That money will be going to shore up banks and to buy assets — and those assets will have some value. It just isn't clear right now what exactly that value will be.

With additional reporting by The Associated Press.