- The Washington Times - Wednesday, February 6, 2008

The Dow Jones Industrial Average yesterday plummeted 370 points on evidence that the nation’s vast service sector — the 90 percent of the nation’s economy that ordinarily produces steady growth — fell into recession territory last month.

Investors who were cheered last week by deep interest-rate cuts succumbed to renewed worries that the economic and market turmoil is far from over. All the major stock indexes lost 3 percent or more of their value, adding to losses as high as 13 percent since the beginning of the year.

The plunge was sparked by an unexpected drop to levels not seen since the 2001 recession in an index measuring services employment and output published by the Institute for Supply Management. The measure of health care, education, transportation and other services has never dropped so precipitously in one month.

“This came as a shocker,” said David Ader, bond strategist at RBS Greenwich Capital. Stock investors had hoped much of the worst news about the economy was behind them, and many Wall Street gurus had been advising clients to start buying stocks again in anticipation of an economic recovery.

The deep slump in the service sector prompted RBS and other forecasters to lower their estimates for economic growth this year to zero or below. Even Jeffrey Lacker, the normally upbeat president of the Federal Reserve Bank of Richmond, conceded “the possibility of a mild recession” in remarks that added to the market’s woes.

“It suggests the bulk of the economy fell out of bed in January,” said Roger M. Kubarych, economist at Unicredit Markets. But he said recent changes the institute made in the index likely exaggerated the decline. While it is the only index that measures the overall services sector, it is a relatively new one, having only been published since 1997.

“This has to be taken with a grain of salt,” Mr. Kubarych said, especially since other economic reports out recently haven’t shown the same pronounced weakness. The jobs report on Friday, for example, revealed an overall loss of jobs during the month, but employment growth was still strong in health care, education and some other service industries.

But other economists said the plunge in services was consistent with recent news of depressed sales, including a 6 percent drop in auto sales during the month. David Rosenberg, economist at Merrill Lynch, said the abrupt decline in services, when combined with the collapse in auto sales and unprecedented tightening of credit conditions, “adds to our concern that we are facing a much deeper downturn than we saw in 2001.”

The latest dismal reading on the economy came as ratings agencies continued to roil the markets with downgrades and threatened downgrades of mortgage-backed securities, bond insurers, banks and securities firms.

Fitch said rising defaults may prompt it to cut the ratings of the largest bond insurer, MBIA Inc., as well as half of the $220 billion of collateralized debt obligations it rates.

Standard & Poor’s Corp., which last week threatened to downgrade MBIA and nearly half the mortgage securities it rates, yesterday warned that such downgrades will lead to further market turmoil as well as financial problems at major banks and securities firms.

“Bond insurers are suffering as a result of their roles as guarantors of mortgage-related securities, and downgrading them could affect all markets in which they are active, including the municipal bond, commercial mortgage-backed securities, and other structured finance areas,” said Standard & Poor’s credit analyst Tanya Azarchs.

“In turn, dislocation in those markets could affect banks. We believe that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades. Large global institutions have direct exposure to the bond insurers in a number of ways,” she said.

S&P; also slashed to junk levels the rating of Fremont General Corp., a California bank that was put under a federal cease and desist order for its subprime mortgage activities last year, while it cut the rating of one of the largest credit unions, U.S. Central Federal Credit Union of Lenexa, Kan., citing a drop in value of its mortgage holdings.

The agency said the prospect of rising defaults and a possible recession due to the further weakening in the housing market to levels not seen since the early 1990s will compound the financial difficulties of all financial institutions.

Jeffrey Kleintop, chief investment strategist at LPL Financial who has been urging investors to buy stocks, said he remains optimistic about the prospect for stocks of nonfinancial companies.

“Incoming earnings reports reflected broad strength in earnings outside the financial sector,” he said. “While the market has been pricing in a recession, we believe the economy is experiencing a midcycle slowdown similar to those seen in the last two business cycles.”

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