By Julian Delasantellis
It is a common perception that the Latin phrase "vox populi, vox dei" must have derived from out of the mouths of one the great oratorical giants of the ancient Roman republic such as Cato or Cicero; its translation, "the voice of the people is the voice of God," sounds all too much like the type of focus group fluff that contemporaneous political speechwriters and spinmeisters provide for their bosses to read in between bites of homemade sausage at the county fair.
What purpose could "vox populi, vox dei" serve other than to proclaim the innate moral superiority of democratic societies?
The truth provides an illustration of the importance of always examining quotes, or just about any other information for that matter, in their original context.
Current thinking posits the actual authorship of the phrase to Flaccus Albinus Alcuinus, a court scholar to Charlemagne in the late 8th century AD.
The Carolingian rulers of Western Europe were not at all renowned for their overwhelming devotion to the democratic ideal, so that makes the association of the phrase with this era and regime somewhat surprising - until you get to the actual quote in which "vox populi, vox dei" was contained.
"And those people should not be listened to who keep saying the voice of the people is the voice of God, since the riotousness of the crowd is always very close to madness."
Besides "the riotousness of the crowd is always very close to madness" being just about the best way to describe what happened in US real estate over the past few years, the misinterpretation of "vox populi" is evocative of those movie studios which, when promoting a new film that has garnered horrific reviews, turn a reviewer’s prose such as "Watching this movie was an amazing waste of time" into "Watching this movie was an amazing time."
There can be little doubt which interpretation of "vox populi" - the modern populist one or the actual elitist one - American economic officials, especially Ben Bernanke and the other governors of the Federal Reserve system, ascribe to. Actually, recent news reports would probably most accurately describe their view of the matter as "vox denique res, vox dei" - roughly translatable to "The voice of the financial services industry is the voice of God."
Over the course of the 42 days between last August 7 and September 18, the US Federal Reserve initiated a reversal in policy direction and emphasis so momentous and comprehensive that the last time anything comparable to it was seen in Washington DC was when Ann Coulter made her last visit to her haberdasher with entirely new policy guidance as to how she wanted her trousers tailored.
After topping out over 14,000 for the first time on July 19, credit fears deriving from renewed concern over the spreading effects of the subprime mortgage crisis caused the US Dow Jones Industrial Average to lose over 1,000 points in the next 9 trading sessions. It was in this atmosphere of extreme market nervousness that the Federal Reserve Board initiated its 2-day midsummer meeting, on August 6.
After raising short-term interest rates 17 times between June 2004 and June 2006, the former Alan Greenspan Fed and by then the Ben Bernanke Fed had been holding interest rate policy steady for over a year as the August meeting commenced. A few observers suggested that, with crude oil prices still rising towards records, generating concerns of a late 1970s-type inflationary spiral, the August meeting might actually result in a resumption of the interest rate hikes in order to tamp down on economic growth and its attendant inflationary risks.
This was a minority view. A greater portion of the worldwide Federal Reserve peanut gallery looked out over the ever darkening economic landscape, noted the trouble that the subprime mortgage borrowers were in as their low, introductory rate mortgages were resetting to much higher rates. This was generating fears that the subprime situation, and the attendant problems it was causing in the world’s equity market and banking sectors, would seriously threaten future economic growth; these observers predicted that the Federal Reserve would begin to cut rates.
In the end, both sides were wrong, as the Fed held rates steady on August 7, but in their post-meeting statements and released minutes, the Fed gave every indication that it was still far more concerned with the possibility of resurgent inflation than it was with the travails of the poor subprime borrowers.
From the statement released by the Fed after the August 7 meeting: "A sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures. Although the downside risks to growth have increased somewhat, the committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."
Three weeks later, the minutes from the August 7 meeting were released, once again demonstrating that on that day inflation was still very much the dominant concern for the Fed.
"Participants remained concerned about factors that could augment inflation pressures, including the continuing high level of resource utilization and slower trend growth in productivity. Some also pointed to the strength of aggregate demand worldwide and the depreciation of the dollar, and their potential effects on the prices of imports and globally traded commodities, as contributing to upside risks to US inflation."
As for the economy, the Fed saw every reason to see more sunny skies ahead: "The expansion would be supported by solid job gains and rising real incomes that would bolster consumption, and by increasing foreign demand for goods and services produced in the United States … the economy seemed likely to continue to expand moderately in coming quarters, supported by solid growth in employment and incomes and by robust economic growth abroad."
Even among the dark clouds of the subprime crisis, the Fed found the silver lining. Credit quality fears had caused a flight to safety into US Treasury securities, lowering their yield, so the long-term mortgage rates tied to Treasury rates had also declined.
"Participants also observed that mortgage loans remained readily available to most potential borrowers, and that interest rates on conforming, conventional mortgage loans had declined in recent weeks, providing some support to the housing sector."
Stock market selling resumed immediately after the Fed’s views hit the markets, and by late in the afternoon of August 9, two days later, it was time for the great policy reversal to commence. At an emergency conference call, the Fed decided that there had been a remarkable deterioration in the economic outlook in just the 2 ˝ days since the last statement.
"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably."
The policy actions to be implemented following the conference call would be increased "interventions" (reported at the time to be in the neighborhood of US$130 billion) in the short-term money markets, to defuse the now obvious liquidity crisis that was driving short-term interbank rates above the Fed’s 5.25% target zone. (I discussed the August 10 events in my August 14 ATol article, Central banks' easy virtue, easy money.)
But still the situation looked threatening. On August 16, the Dow Jones Industrial Average went into an early morning freefall, losing 400 points to bottom out at 12,500, making it a 1,500 point drop from the previous month's highs; it rallied into the close to finish off just 16 points for the day. The VIX option volatility/market fear index reached its highest point since the index was recalibrated in 2004.
This led to another Fed emergency conference call. At its conclusion, the Fed announced its first interest rate cut in over 4 years, a 50 point cut in the discount rate that the Fed charges its member banks for emergency borrowing (see When the big guns fail, call in China).
In marked contrast to the rosy picture of just the previous week, the Fed now reported that "Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."
August 16 marked the lows (so far) in US equity markets, but the Fed's interest rate reversal still had one more act to play. On September 18, at the its next regularly scheduled meeting, the Fed surprised the markets with 50 basis point cuts of both the discount and the Federal funds target rates, the most aggressive Fed easing move since late 2002.
According to the Fed’s statement and meeting minutes, things sure had changed since those blissful, prosperous days of early August. "Weakness in employment was spread fairly widely across industries. Residential construction and manufacturing posted noticeable declines in jobs, employment in wholesale trade and transportation was little changed, and hiring at business services was well below recent trends … trend growth in jobs had fallen off even prior to the recent financial market strains, and participants judged that some further slowing of employment growth was likely … some recent data and anecdotal information pointed to a possible nascent slowdown in the pace of expansion. Given the unusual nature of the current financial shock, participants regarded the outlook for economic activity as characterized by particularly high uncertainty, with the risks to growth skewed to the downside."
What about all that concern about inflation expressed during the August meeting? As they might say in Brooklyn, "Fuhgeddaboudit!"
The board "recognized that incoming data on core inflation continued to be favorable, and they generally were a little more confident that the decline in inflation earlier this year would be sustained. Inflation expectations seemed to be contained, and the less robust economic outlook implied somewhat less pressure on resources going forward."
The key period here is those couple of days after the August 7 meeting but before the first market interventions of August 10. What were the factors that caused the great ship Bernanke to start the process of an emergency 180 degree turn of the policy rudder?
We all can wonder and speculate as to what was happening up there at those most august levels of economic policymaking, but it was Wharton School of Finance lecturer Dr Ken Thomas who actually went out and tried to find some answers. In doing so, if they give an annual award to the cheekiest bastard in the news, Dr Thomas will certainly get my vote in 2007.
Through employment of the US government’s Freedom of Information Act, the 1966 legislation that allows American citizens relatively unrestricted access to government documents not protected by a national security or criminal justice privilege, Thomas requested and received Bernanke’s appointment and phone logs for that critical August 7-9 period.
Who had Bernanke's ear and attention during this period? Here's a hint: if your net worth was under $100 million or so, or you were representing interests of under $1 billion or so, you probably were going to be put on hold.
Late in the day of August 8, a little over 24 hours following the Fed's stand pat decision of August 7, Bernanke took a call from the former Clinton era treasury secretary and current director and chairman of the executive committee of Citigroup, Robert Rubin, the man whose picture encyclopedias should probably use to illustrate the entry for "the establishment".
The phone logs do not indicate the nature or specifics of the conversation, but it is reasonable to assume that Rubin was telling Bernanke that actual conditions out there in the markets were not nearly as rubicund as the previous day's chipper post-meeting statement indicated.
Sure enough, the next day, August 9, the Dow Jones Industrials opened down 230 points.
"Ring!" "Hello, Chairman Bernanke’s office."
August 9 was the day that the rest of the tag team went to work At 11am, in walked into Bernanke’s office none other than Lewis Raineri, the man who, when working as a bond trader at Salomon Brothers (now folded into, yes, Robert Rubin’s Citigroup) in the early 1980s is credited with the actual creation of the mortgage backed securities market now at the core of the subprime mess. More recently, Raineri had founded the Hyperion group of private equity hedge funds; it is entirely reasonable to assume that Hyperion then had more than a few of those endangered subprime collateralized debt obligations dragging down its ledger books.
And still they kept coming. At 2pm, Raymond Dalio, head of Bridgewater Associates, the fourth largest US hedge fund, along with other hedge fund honchos, met with Bernanke. (It must have been murder trying to get air traffic control clearance for private jets flying from the New York area into Washington airspace that day.) In my October 2 ATol article, No such thing as a Sure Thing, I described how it was the market's simultaneous turning against many of the hedge funds most popular trading strategies that led to the steep equity market declines of early August, so it is more than reasonable to assume that these important gentlemen did not make these previously unscheduled trips down to Washington just to talk baseball scores or American Idol contestants.
Like kids who keep pestering a grownup for a toy until they get what they want, by 4:30 that afternoon Bernanke had heard enough. He initiated the Fed conference call that, when announced before the market's opening the following morning, led to the open market interventions that commenced the interest rate easing cycle.
Two things stand out from Dr Thomas' findings. One is that there is absolutely no suggestion that the plight of the quarter of a million or so Americans now losing their homes through foreclosure every month had any import or consideration at all in these events. Nowhere in the logs is there any indication that Bernanke had, or made any attempt to, contact those many community organizations that are now, in a mostly futile cause, attempting to save the unfortunate subprime borrowers from their impending foreclosure.
Even more striking is the fact that, just like your mother probably once told you, hanging around with the wrong type of people sends a bad message about you, for Bernanke to so clearly be accepting policy advice from these market types at that time sends a very questionable message about how serious he actually is in not wanting to be seen rewarding those who make poor investment choices - the economic regulatory conundrum known as "moral hazard".
As I’ve written before on these pages, "moral hazard" involves rewarding imprudent financial risk takers by not making them feel the full penalty, specifically, insolvency and bankruptcy, if their investment or speculative decision-making proves faulty. By moving to inject reserves into the system Bernanke was acting to keep the losses manageable for the big speculators represented by Raineri and Dalio, and to support the financial system as a whole, as represented by Rubin. At least in terms of costs and risks to the financial system as a whole, and to US taxpayers in particular, Ben Bernanke has proved that he is more than willing to troll with some very shady characters, in some very questionable neighborhoods.
In the early 1980s, the old line US stock brokerage firm E F Hutton (nowadays, after many successive iterations of mergers and buyouts, just another digestive of, yes, Robert Rubin's Citigroup) garnered significant pop culture buzz with its series of "When E F Hutton speaks ..." television advertisements.
These spots featured two obviously well off people talking in an upscale setting, such as a fancy restaurant or on the golf course. One person talks about some recent advice he has received from his stockbroker. The other person’s rejoinder went along the lines of, "well, my broker is E F Hutton, and Hutton says ..." Immediately, all those within earshot, whether at adjoining tables or nearby fairways, would cease whatever they were doing, lean in and cock their heads so as to better hear these supposed pearls of investing wisdom.
The ads were spoofed in the 1983 movie Trading Places as an entire restaurant full of dining sophisticates leaned in close to hear ghetto hustler turned commodity futures arriviste Billy Ray Valentine’s call on the wheat market.
Of course, what the travails of August now teach us is that "When the most speculative sectors of the financial services industry speak, Ben Bernanke listens." So that he can do exactly what they tell him to do.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
(Copyright 2007 Asia Times Online Ltd. All rights reserved. )
Wednesday, October 17, 2007
Triangular trouble: Euro, dollar and yuan
By Thomas I Palley
For the past several years the euro has been appreciating steadily against the US dollar. Given the Chinese yuan and other East Asian currencies are pegged to the dollar, that means the euro has been appreciating steadily against all. This spells trouble for euroland, and it suggests European policymakers should join with the US to address the global problem of under-valued currencies.
The euro has now appreciated approximately 70% relative to its historic low against the dollar, set on October 26, 2000. This appreciation has been economically justified given Europe’s large trade surplus with the United States. That surplus peaked in 2005 and is now gradually coming down as the Euro appreciates, which is exactly how a market-based global economy is supposed to correct international financial imbalances.
Some in Europe are beginning to raise red flags regarding this appreciation, but the reality is it is still within the bounds of reasonableness. Though the euro has appreciated 70% against its historic low, it has only appreciated 20% relative to its January 1999 introductory parity.
That said, European concerns about exchange rates are justified, but the focus should be East Asia’s currencies, not the dollar. The key player is China, which has the largest surplus. Additionally, other East Asian countries are rationally reluctant to adjust their currencies absent a Chinese revaluation, as they fear losing competitiveness. This means China’s refusal to significantly revalue its currency against the dollar is forcing a lop-sided adjustment process that places the burden of rebalancing the US trade deficit exclusively on Europe. That is imposing a deflationary burden on Europe that could easily undermine the European economy.
Europe is now experiencing double trouble as its surplus with the US begins to fall while its deficit with China is large and growing. Between 2002 and 2006 the European Union’s deficit with China rose from 54 billion euros to 128 billion euros. At current exchange rates the 2006 deficit was $179 billion, and the EU Chamber of Commerce expects that deficit to hit $260 billion in 2007.
In a sense, Europe now finds itself involuntarily on the same path that the US voluntarily locked itself into in the late 1990s. That path is characterized by rising trade deficits, weakened manufacturing investment spending, and loss of manufacturing jobs.
The yuan’s under-valuation stands to lower European exports and increase imports from China as spending is redirected from European produced goods to cheaper Chinese goods. The resulting increased trade deficit will directly cost jobs, and reduced demand and profitability of European manufacturing companies will reduce investment spending. Furthermore, European manufacturers will have an incentive to close plants and shift production and new investment to China, just as happened in the US.
These effects are likely to be especially disruptive from a regional perspective. Whereas Germany’s high value-added capital goods exporters may still be able to prosper, the economies of Italy, Spain, and other Mediterranean countries stand to be badly impacted. Additionally, manufacturing in Central Europe’s new member states stands to be severely affected, making their integration into the European economy more difficult.
The bottom line is that by all reasonable standards China’s currency is under-valued against both the dollar and the euro. China is running huge and growing trade surpluses with both Europe and the US; it has a growing global trade surplus; and on top of that it has an even larger current account surplus since its trade surplus is supplemented by massive foreign direct investment inflows.
These conditions suggest Europe and the US have a common interest in closely cooperating to pressure China to adjust its currency. Yet, so far, that has not happened. One reason is that until recently the euro was under-valued so that Europe had no grounds for or interest in pressuring China to revalue. A second reason is that Europe and the US are in competition for sales to China and each may fear antagonizing the Chinese government.
This has triangulated Europe and the US to their disadvantage and to the benefit of China. The implication is that fixing the structural problem of triangulation and remedying the failure to cooperate on the China currency question should be urgent policy priorities for both sides of the North Atlantic partnership.
(Copyright 2007, Copyright Thomas I Palley)
For the past several years the euro has been appreciating steadily against the US dollar. Given the Chinese yuan and other East Asian currencies are pegged to the dollar, that means the euro has been appreciating steadily against all. This spells trouble for euroland, and it suggests European policymakers should join with the US to address the global problem of under-valued currencies.
The euro has now appreciated approximately 70% relative to its historic low against the dollar, set on October 26, 2000. This appreciation has been economically justified given Europe’s large trade surplus with the United States. That surplus peaked in 2005 and is now gradually coming down as the Euro appreciates, which is exactly how a market-based global economy is supposed to correct international financial imbalances.
Some in Europe are beginning to raise red flags regarding this appreciation, but the reality is it is still within the bounds of reasonableness. Though the euro has appreciated 70% against its historic low, it has only appreciated 20% relative to its January 1999 introductory parity.
That said, European concerns about exchange rates are justified, but the focus should be East Asia’s currencies, not the dollar. The key player is China, which has the largest surplus. Additionally, other East Asian countries are rationally reluctant to adjust their currencies absent a Chinese revaluation, as they fear losing competitiveness. This means China’s refusal to significantly revalue its currency against the dollar is forcing a lop-sided adjustment process that places the burden of rebalancing the US trade deficit exclusively on Europe. That is imposing a deflationary burden on Europe that could easily undermine the European economy.
Europe is now experiencing double trouble as its surplus with the US begins to fall while its deficit with China is large and growing. Between 2002 and 2006 the European Union’s deficit with China rose from 54 billion euros to 128 billion euros. At current exchange rates the 2006 deficit was $179 billion, and the EU Chamber of Commerce expects that deficit to hit $260 billion in 2007.
In a sense, Europe now finds itself involuntarily on the same path that the US voluntarily locked itself into in the late 1990s. That path is characterized by rising trade deficits, weakened manufacturing investment spending, and loss of manufacturing jobs.
The yuan’s under-valuation stands to lower European exports and increase imports from China as spending is redirected from European produced goods to cheaper Chinese goods. The resulting increased trade deficit will directly cost jobs, and reduced demand and profitability of European manufacturing companies will reduce investment spending. Furthermore, European manufacturers will have an incentive to close plants and shift production and new investment to China, just as happened in the US.
These effects are likely to be especially disruptive from a regional perspective. Whereas Germany’s high value-added capital goods exporters may still be able to prosper, the economies of Italy, Spain, and other Mediterranean countries stand to be badly impacted. Additionally, manufacturing in Central Europe’s new member states stands to be severely affected, making their integration into the European economy more difficult.
The bottom line is that by all reasonable standards China’s currency is under-valued against both the dollar and the euro. China is running huge and growing trade surpluses with both Europe and the US; it has a growing global trade surplus; and on top of that it has an even larger current account surplus since its trade surplus is supplemented by massive foreign direct investment inflows.
These conditions suggest Europe and the US have a common interest in closely cooperating to pressure China to adjust its currency. Yet, so far, that has not happened. One reason is that until recently the euro was under-valued so that Europe had no grounds for or interest in pressuring China to revalue. A second reason is that Europe and the US are in competition for sales to China and each may fear antagonizing the Chinese government.
This has triangulated Europe and the US to their disadvantage and to the benefit of China. The implication is that fixing the structural problem of triangulation and remedying the failure to cooperate on the China currency question should be urgent policy priorities for both sides of the North Atlantic partnership.
(Copyright 2007, Copyright Thomas I Palley)
Wall Street falls
NEW YORK (AP) - Wall Street sank for a second straight session Tuesday after Federal Reserve Chairman Ben Bernanke said the slumping housing market remains a "significant drag'' on the economy.
Bernanke's speech Monday night in New York elevated concerns that the summer's credit tightness might persist into the winter _ a sobering thought for investors, who are sifting through mixed third-quarter earnings and watching energy costs rise.
"First of all, the worry is we're getting more bad news on housing. No. 2 is higher oil prices. That's a pretty bad combination,'' said Hugh Johnson, chief investment officer of Johnson Illington Advisors.
Crude oil prices spiked to another record above $88, and a National Association of Home Builders' index that tracks developers' expectations of future home sales fell for the eighth consecutive month to the lowest point since January 1985.
Also Tuesday, Treasury Secretary Henry Paulson echoed Bernanke's concerns, saying the housing market is a significant risk to the economy.
The ensuing uncertainty on Wall Street about the economic outlook "comes at a time when earnings results are not particularly exciting - in fact, are dismal,'' Johnson said.
A day after Citigroup Inc. reported a steep third-quarter profit decline and announced plans with a consortium of banks to set up a fund to help bail out the credit markets, two more banks released disappointing results.
Wells Fargo & Co. shares fell 4 percent after the bank said third-quarter earnings increased by less than analysts anticipated and that it boosted loan loss reserves in preparation for more problems in consumer credit.
KeyCorp shares declined nearly 6 percent after the Midwest regional bank posted a 33 percent drop in third-quarter profit.
The Dow Jones industrial average fell 71.86, or 0.51 percent, to 13,912.94, after falling more than 100 points earlier in the session.
Broader indicators also declined.
The Standard & Poor's 500 index slid 10.18, or 0.66 percent, to 1,538.53, and the Nasdaq composite index dipped 16.14, or 0.58 percent, to 2,763.91.
Bond prices rose as investors pulled money out of stocks.
The yield on the 10-year Treasury note, which moves inversely to the price, fell to 4.66 percent from 4.68 percent at Monday's close.
The dollar rose against most currencies. Gold also rose.
On Monday, the Dow and the S&P posted their biggest point drops in five weeks; just last week, the two indexes had touched record highs.
"The relief rally that we've enjoyed since Aug. 16, the day before the Fed cut the discount rate, has been an impressive one. And it will probably still push stock prices higher the rest of the year,'' said Edward Yardeni, an economist who runs Yardeni Research in Great Neck, New York.
But, he added, "the first batch of earnings news for the third quarter gives some reason for concern, particularly for the banks, who are probably going to continue to have problems with their own portfolios.''
Bernanke said Monday night the deepening housing slump will probably keep dragging on economic growth, but he again pledged to "act as needed'' to help financial markets that seized up this summer.
He also said inflation remains in check - which could convince policymakers to cut interest rates for the second month in a row at their Oct. 30-31 meeting.
But while core inflation - which excludes volatile food and energy prices - is mild, oil prices are pushing further into uncharted territory on speculation about supply disruptions.
Crude futures rose $1.48 to a record close of $87.61 a barrel on the New York Mercantile Exchange, after briefly surpassing $88.
Declining issues outnumbered advancers by about 8 to 3 on the New York Stock Exchange.
Volume came to 1.29 million shares. Most financial and housing-related stocks fell, as did retailers.
A couple bright spots in the financial sector were State Street Corp., a trust bank that posted a profit rise of 29 percent on strong revenue from servicing fees and trading services, and Bear Stearns Cos.
A bank owned by the investment arm of China's cabinet is planning a bid for a stake in the brokerage.
State Street rose $5.75, or 8.3 percent, to $74.68.
Bear Stearns rose $2.36, or 2 percent, to $123.05.
Bernanke's speech Monday night in New York elevated concerns that the summer's credit tightness might persist into the winter _ a sobering thought for investors, who are sifting through mixed third-quarter earnings and watching energy costs rise.
"First of all, the worry is we're getting more bad news on housing. No. 2 is higher oil prices. That's a pretty bad combination,'' said Hugh Johnson, chief investment officer of Johnson Illington Advisors.
Crude oil prices spiked to another record above $88, and a National Association of Home Builders' index that tracks developers' expectations of future home sales fell for the eighth consecutive month to the lowest point since January 1985.
Also Tuesday, Treasury Secretary Henry Paulson echoed Bernanke's concerns, saying the housing market is a significant risk to the economy.
The ensuing uncertainty on Wall Street about the economic outlook "comes at a time when earnings results are not particularly exciting - in fact, are dismal,'' Johnson said.
A day after Citigroup Inc. reported a steep third-quarter profit decline and announced plans with a consortium of banks to set up a fund to help bail out the credit markets, two more banks released disappointing results.
Wells Fargo & Co. shares fell 4 percent after the bank said third-quarter earnings increased by less than analysts anticipated and that it boosted loan loss reserves in preparation for more problems in consumer credit.
KeyCorp shares declined nearly 6 percent after the Midwest regional bank posted a 33 percent drop in third-quarter profit.
The Dow Jones industrial average fell 71.86, or 0.51 percent, to 13,912.94, after falling more than 100 points earlier in the session.
Broader indicators also declined.
The Standard & Poor's 500 index slid 10.18, or 0.66 percent, to 1,538.53, and the Nasdaq composite index dipped 16.14, or 0.58 percent, to 2,763.91.
Bond prices rose as investors pulled money out of stocks.
The yield on the 10-year Treasury note, which moves inversely to the price, fell to 4.66 percent from 4.68 percent at Monday's close.
The dollar rose against most currencies. Gold also rose.
On Monday, the Dow and the S&P posted their biggest point drops in five weeks; just last week, the two indexes had touched record highs.
"The relief rally that we've enjoyed since Aug. 16, the day before the Fed cut the discount rate, has been an impressive one. And it will probably still push stock prices higher the rest of the year,'' said Edward Yardeni, an economist who runs Yardeni Research in Great Neck, New York.
But, he added, "the first batch of earnings news for the third quarter gives some reason for concern, particularly for the banks, who are probably going to continue to have problems with their own portfolios.''
Bernanke said Monday night the deepening housing slump will probably keep dragging on economic growth, but he again pledged to "act as needed'' to help financial markets that seized up this summer.
He also said inflation remains in check - which could convince policymakers to cut interest rates for the second month in a row at their Oct. 30-31 meeting.
But while core inflation - which excludes volatile food and energy prices - is mild, oil prices are pushing further into uncharted territory on speculation about supply disruptions.
Crude futures rose $1.48 to a record close of $87.61 a barrel on the New York Mercantile Exchange, after briefly surpassing $88.
Declining issues outnumbered advancers by about 8 to 3 on the New York Stock Exchange.
Volume came to 1.29 million shares. Most financial and housing-related stocks fell, as did retailers.
A couple bright spots in the financial sector were State Street Corp., a trust bank that posted a profit rise of 29 percent on strong revenue from servicing fees and trading services, and Bear Stearns Cos.
A bank owned by the investment arm of China's cabinet is planning a bid for a stake in the brokerage.
State Street rose $5.75, or 8.3 percent, to $74.68.
Bear Stearns rose $2.36, or 2 percent, to $123.05.
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