Stocks plunge as investors flee risk

The continuing aftershocks of the housing bust send Wall Street's moneymen running for cover.

By Andrew Leonard

Published July 26, 2007 5:05PM (EDT)

As of 1 p.m. Eastern, the Dow Jones industrial average had dropped 260 points. Yes, yes, we know, a sharp rise or fall in the Dow on any single given day may mean little in and of itself. But when the index drops almost 300 points in three hours, one still feels compelled to pay attention -- especially when there is a clear and obvious reason why investors are spooked: The price of insuring against risk is going through the roof. (UPDATE: The Dow ultimately closed down 311 points.)

Bloomberg is reporting that the cost of credit-default swaps, a type of derivative that is "used to bet on the ability of companies to repay debt, is the highest in more than two years." The Wall Street Journal reports that "a swelling wave of risk aversion" is sweeping the financial landscape, which is a polite way of saying that people are freaking out. Perhaps the best quote of all comes from the Financial Times and Tom Murphy, corporate-sector team leader at Ameriprise Financial.

"The market has issues," said Murphy.

Bluntly put, Wall Street's biggest investors are suddenly frantic that they are going to end up stuck with the bill for a half-decade of partying. For years, analysts have been warning that investors seemed to have forgotten that high yields imply high risks. It became so easy to buy insurance against the possibility of a bank default or other financial disaster that no one gave a second thought to the task of borrowing billions of dollars for a leveraged buyout or exotic hedge fund bet.

The collapse of the subprime mortgage lending industry appears to have ushered in a new sense of reality. The party is over, or at least that's what investors think, right now.

Naturally, it's always possible that at any moment traders will see this "correction" as a "buying opportunity" and rush back again, reversing the plummet -- and there are some signs, even as I write these words, that that might be happening.

But even if the Dow recovers, the jitters aren't going to go away. The news from the housing market this week has been unremittingly glum. On Thursday morning, new-home sales took another big hit, down 6.6 percent month-on-month and 23 percent year-on-year. Since the housing bust is what exposed the weaknesses in Wall Street's operating models in the first place, the new numbers aren't encouraging. The fractures that have already split open seem doomed to widen.

Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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