What will steady shaky financial system?

Two keys: Stabilize home values while keeping Wall Street calm, analysts say.

By , Staff writer of The Christian Science Monitor

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    Involved: Treasury Secretary Henry Paulson said Tuesday that markets must remain stable.
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After months of wrenching upheaval in financial markets, the system hasn't self-destructed but it also hasn't stabilized.

What will it take?

With the nation now very likely in a recession, that's become an important question not just for bankers and policymakers, but for everyday workers and consumers.

Recommended: Recession in America? 10 questions assessing the threat.

Many signposts will mark the path forward, economists say, but they cite two crucial steps policymakers must make. First: Ensure that the current uncertainty about the value of houses is resolved, which will also help investors discover the now-uncertain value of mortgage-linked investments. Second: Prevent chaos from engulfing the financial system while that housing adjustment is taking place.

Unfortunately, the first step may take a while – many more months – and the second will continue to tax policymakers during that time.

Still, several recent signs are encouraging, including the apparent determination by Federal Reserve Chairman Ben Bernanke to move creatively and decisively when market jam-ups occur. He and his team are also lowering interest rates, including a move Tuesday that dropped the so-called federal funds rate from 3 percent to 2.25 percent.

"Bernanke's doing everything he can to end it," says Brian Horrigan, chief economist at Loomis Sayles, a Boston mutual fund manager. But "he can't miraculously change a bad asset to a good asset."

Experts differ widely on how far advanced the current financial crisis is. Some say it could last several more years, while others say the stock market may be near bottom now.

A sure indicator, Mr. Horrigan says, will be when "vultures" – aggressive, bottom-fishing investors – start moving in to buy investments that have tanked in the hands of others. In the current crisis, those investments include packages of debt that include subprime mortgages.

"That's how crises come to an end," Horrigan says. "Someone starts buying."

This is why home prices are so important. Buying of homes or of mortgage securities can best rebound on confidence that prices are near a bottom.

"The [economic] downturn was triggered by the bursting of a housing bubble," says Jared Bernstein, an economist at the Economic Policy Institute, a left-leaning Washington think tank. "As long as home prices have a way to go, it's hard to see much light at the end of the tunnel."

He cites a forecast of home prices shared by a number of analysts: "Home prices are down 10 percent, and probably have another 10 percent to go. By that very simple measure, you could argue we are halfway through the tunnel."

A key question is if policy intervention will hasten the process – or prolong it.

The argument for intervention is that the market is in such chaos now that home prices could fall too far. A wave of foreclosures is adding to an already large inventory of homes for sale. And in a vicious cycle, the further home prices fall, the more people may default on their loans.

Some analysts say the end of the crisis will be near when Congress takes some new action to stem the foreclosure tide. This could be structured, supporters say, so that it is not a bailout for lenders or borrowers – and so that it allows home prices to fall to a new equilibrium.

"I like many aspects of this Barney Frank plan," Mr. Bernstein says, referring to a bill proposed by the US Democratic congressman from Massachusetts. "That's a potentially good way of accelerating price discovery," as well as preventing some foreclosures.

But others worry that intervention will only slow the housing market correction. "It would be a terrible idea for the government to intervene in the housing market," says Michael Cosgrove, who publishes the EconoClast newsletter in Dallas.

He says that financial markets have already processed much of the bad news. And he says that even if housing prices haven't bottomed out, by later this year "the economy can turn around."

Whether he's right or not, some recent signs are encouraging:

• The vultures are circling, and in some cases starting to buy. Wilbur Ross, a billionaire who has invested in ailing Rust Belt firms, has turned his attention to financial-sector opportunities. He moved this week to buy Option One, a mortgage division of H&R Block.

• Institutions are moving to raise capital as a cushion against potential losses. For example, Fannie Mae and Freddie Mac, enterprises that underwrite mortgage loans with government oversight, are close to such a step, according to a Reuters report. Their action would help ensure that home loans continue to be made during tough times.

• The collapse of the investment house Bear Stearns over the weekend is good news in one sense. The implosion – caused by a run by worried customers – signals that investors are moving to sift chaff from wheat. In this climate, bad home loans and other financial "toxic waste" will rise to the surface to be purged.

• The federal intervention Sunday to keep Bear Stearns out of bankruptcy is also good news, analysts say. It involved a forced merger of Bear into JPMorgan Chase, not a bailout. The action prevented wider chaos that could have rippled out to the many firms that deal with Bear – and the whole economy.

Some economists say the financial mess is big enough that it will require even more mop-up efforts by bank regulators at insolvent firms.

As the economy worsens, the bad-loan problems are spreading from mortgages to other forms of credit, for one thing.

The better the economy does, the smaller the cleanup.

In interviews Tuesday, Treasury Secretary Henry Paulson noted that rebate checks for taxpayers – part of an economic stimulus package – will arrive starting May 2. "We need to keep our capital markets stable, functioning well," Mr. Paulson told NBC.

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