Some signs of optimism on economy

Banks raise capital; senators look at a bipartisan mortgage-rescue package.

Jonathan Ernst/Reuters
Bernanke: He testified before Congress Wednesday.
SOURCE: MKM Partners, using data from the National Association of Realtors/Rich Clabaugh–STAFF

America's web of housing and financial problems has no simple or quick fix, but one vital ingredient of progress appears to be on the rise: hope.

A 3.6 percent surge of the Standard & Poor's stock index, as happened Tuesday, is hardly an all-clear signal. But the fact that the rally was led by some of the bank stocks at the center of the storm does point to some lessening of fears that neither markets nor policymakers can prevent an economic slowdown from becoming a deep recession.

Among the encouraging signs:

•Banks are raising fresh capital. The investment banks UBS and Lehman Brothers moved this week to raise $19 billion by issuing new stock shares. That money represents the wherewithal for new lending and a cushion against potential losses.

•Republicans and the majority Democrats in the Senate agreed Tuesday to craft a mortgage rescue package on bipartisan grounds. The impact would be modest, but many analysts say it could provide some help to the economy's key area of weakness.

•In recent weeks, an index of home affordability has moved convincingly above average, a step that could lay the groundwork for buyers to begin to return to the housing market.

"The [stock] rally was indeed about hope. At least for one day hope trumped fear," says Ken Goldstein, an economist at the Conference Board, a business-sponsored research group in New York. "We have certainly extended a safety net of sorts to financial markets."

Don't be surprised, he says, if the stock markets continue their wild swings – with moves down as well as up.

It took a long time for the economy's credit problems to build. Businesses and families "leveraged up" with a borrowing and lending boom that went too far. The aftermath is an unwinding process that can't be accomplished overnight.

Orderly vs. chaotic adjustment

But for American households, what matters greatly is that this unwinding occur in as orderly a way as possible. If things go well, credit will still be available, banks won't fail, and the housing market will find a new equilibrium. This can't prevent a belt-tightening process that may be pushing the economy into a recession.

"Housing is very much at the center of both the economic situation and the credit situation," Federal Reserve Chairman Ben Bernanke said Wednesday on Capitol Hill, responding to questions from Congress's Joint Economic Committee.

He expressed cautious optimism, based in part on the Fed's own recent moves to cut interest rates and to extend short-term credit to banks at a time of stress.

"Our recent actions appear to have helped stabilize the situation somewhat," Mr. Bernanke said. He predicted that economic activity will strengthen later this year and return to sustainable growth in 2009, "bolstered by a stabilization of housing activity, albeit at low levels, and gradually improving financial conditions."

As he spoke, the stock market was steady, holding onto its Tuesday gains.

Still, Bernanke and others point to risks on the down side for the US economy.

Falling home prices, while helping to lure buyers to the market, mean lost wealth for millions of Americans – and the risk of large losses for banks when homes end up in foreclosure. Many fewer families can borrow against home equity like they did in recent years – a practice that buoyed consumer spending and overall economic growth.

Now consumers face not only declining net worth and high debt, but also rising prices for everything from gasoline and food to healthcare.

"There's a real danger of a very sharp contraction in the economy where many jobs will be lost," says Charles McMillion, an economist at MBG Information Services in Washington.

This leaves the Federal Reserve in a difficult position. Lawmakers on Wednesday asked Bernanke whether interest-rate cuts will fan inflation. But they also questioned the wisdom of recent creative moves by the Fed to maintain stability in the banking system – notably its rescue of investment bank Bear Stearns by putting $29 billion of Fed resources on the line.

In this climate, the way forward can seem fraught with difficulties on all fronts. Is optimism justified?

"Both the hope and panic are overblown," says Mr. Goldstein in New York.

It's too soon to say the problems are fading, he explains. But a catastrophic outcome is unlikely, he says.

In the banking sector, losses are large but not necessarily unmanageable. Mortgage-related write-downs may end up totaling $500 billion, and losses on credit cards, industrial loans, and other debts could double that figure, economists at Goldman Sachs estimate.

But because so many debts are packaged for resale to investors, only about half of those losses fall directly on firms such as commercial and investment banks, they reckon. Those firms have recently raised about $100 billion in new capital. The moves by firms such as UBS this week add to that total.

"That was in fact very encouraging," Bernanke said during the hearing.

In the real estate market, prices may have further to fall. Yet both ordinary buyers and investment firms are waiting on the sidelines for now, ready to jump in at some point.

"That line [of potential buyers] has been building for a year and half, and it's going to get longer," says Goldstein. That should build a floor under home prices.

Congress ready to act

Legislation in Congress could also help.

Spending taxpayer money to try to prevent foreclosures is controversial, both among economists and ordinary Americans.

Opponents say the marketplace can best deal with the wave of mortgage defaults. They warn, too, that any bailout will encourage future reckless behavior.

Many proponents say legislation, if it reduces the pace of foreclosures, will help neighborhoods and the whole economy. The legislation now under consideration also attempts to distinguish deserving borrowers from undeserving ones.

The housing slump must ultimately be resolved in the marketplace, Goldstein says. But in his view the measure under review, crafted by Sen. Christopher Dodd (D) of Connecticut, will probably do more good than harm during this time of market stress.

The bill aims to refinance more at-risk borrowers, both by providing money to localities and through Federal Housing Administration loan guarantees.

"If we don't do this … we're going to wind up with more folks that lose their homes," Goldstein says. "It's not just a family that's thrown out in the street. It's not good for that community. And it's no good for the bank."

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