Woes deepen for U.S. economy

Bush says banking system 'basically sound,' but his team urges federal intervention.

SOURCES: Bureau of Labor Statistics, Census Bureau, Yahoo! Finance, Conference Board/© 2008 MCT

Expectations that the current US economic downturn will be shallow are diminishing.

A severe recession in the United States still isn't the mainstream forecast, but economists say it's a real possibility, especially as problems at American banks deepen amid a continuing shakeout of the housing crisis.

What makes forecasts challenging these days is that the economy's problems involve the linkage of many moving parts. Crucially, a healthy banking system is vital to the economy, and now an economic slowdown and a plunge in bank stocks have raised the prospect of more bank failures and the need for federal intervention.

The rising uncertainty and risk were visible Tuesday, from auto manufacturing to the value of the dollar. General Motors canceled dividends for shareholders, something it hasn't done since 1922. The dollar fell to a new low against the euro. Stocks fell worldwide.

Everyone from CEOs to policymakers to ordinary investors and depositors are grappling with the question: How bad is this crisis? How bad could it get?

It's a sign of the times that Federal Reserve Chairman Ben Bernanke, the closest thing to a spokesman for the economy, talked a lot about unknowns even as he sought to reassure lawmakers Tuesday at a congressional hearing. One major question, he said, is how long housing-market declines will persist.

"It's that uncertainty, I think, that is generating a lot of the stress … that we're seeing," he said in response to questioning.

As of June, the Fed's policymaking committee gauged the economy's path looking forward as "below its trend rate" – not necessarily in recession but well below normal growth of 3 percent or so, Mr. Bernanke said.

However, the central bank believes any surprises are more likely to be on the side of weakness, not strength, he said.

While citing an "unusually uncertain" outlook for whether inflation will come back under control, the Fed chairman laid down a marker on another top concern. "Helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve," he said in his prepared statement.

In fact, the Fed was created in 1913 with the goal of preventing and mitigating banking crises.

"The lifeblood of a modern economy is credit," says Ken Goldstein, an economist at the Conference Board, a business research group in New York. "Inability of [mortgage firms] Fannie Mae and Freddie Mac to raise capital could potentially bring them down…. It's exactly why [Treasury Secretary Henry] Paulson and Bernanke have been and are so willing to take extraordinary steps."

For his part, Mr. Goldstein predicts that the economy will escape a steep downturn as it has done over the past year of turmoil, thanks in part to US policy moves.

But those moves are becoming, to use his word, extraordinary.

Fannie and Freddie are corporations that, by buying or guaranteeing home loans, play a central role in the mortgage market. With loan defaults on the rise, they now face a deep erosion of their stock-market value at a time when they may need to raise more capital to cover losses.

To stem concern that Fannie and Freddie might become insolvent, Secretary Paulson is urging Congress to allow the US Treasury to buy an equity stake in the enterprises, if needed, or to enlarge a credit line to them. Paulson and President Bush spoke Tuesday on behalf of this plan, and lawmakers have pledged to give it quick consideration.

"If you're a depositor, you're protected by the federal government," up to $100,000, Mr. Bush said during a news conference. He called the banking system "basically sound."

Bernanke struck a similar note, saying the good news is that banks headed into this crisis well capitalized and with high profits.

Still, mortgage losses are now being joined by rising delinquencies for other types of loans – cars and credit-card debt, for example – because of a cooling economy.

Availability of adequate capital is vital – and is at risk now. The higher loan losses rise, the more they eat into banks' reserves and the more new capital they need to raise.

When share prices of financial firms fall, it becomes more expensive to get investors to put up money.

"If you are in a systematic downward cycle in your stock price, who's going to invest in you?" says Brian Bethune, an economist at Global Insight, a forecasting firm in Lexington, Mass.

"If you had issued 1,000 Fannie Mae shares a year ago, you would have gotten $50,000" in capital, he says. Now, by his rough calculation based on Fannie's share price, you'd get $10,000.

"That just is a crippling blow," Mr. Bethune says.

Few analysts talk of imminent bankruptcy at the largest institutions. But a number of those companies have taken a big hit – losing two-thirds or more of their market value in the past year.

"The financial system in general needs to raise capital," Bethune says. Some private entities that were putting up money a few months ago have been less willing to do so lately.

By some measures, banks' troubles haven't led to a major credit crunch so far. A recent survey of small-business owners, by the National Federation of Independent Businesses, found businesses more concerned with inflation than with access to credit from banks.

By some estimates, mortgage and other losses to financial firms in the current cycle could be $1 trillion. But that depends on what happens in the housing market and the economy, where the jobless rate will affect the performance of loans.

One promising sign, to many analysts, is policymakers' willingness to act. Tax-rebate checks are helping consumers. Congress is working on legislation to help reduce home foreclosures. The Fed is trying to provide short-term liquidity through loans to financial markets.

The latest turmoil makes it less likely the Fed will raise interest rates this fall. That would combat inflation, but Bethune says the possibility of a rate hike is one more thing rattling financial markets.

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