Will bank bailout revive growth?

Banks will still need to recapitalize and start lending again.

Now that Congress appears poised to sign off on a rescue plan for Wall Street, will that save the United States from an economic downturn?

Many economists think not. Even before lawmakers announced a tentative bailout deal early Sunday, the data were showing declines in business spending, a hunkered-down consumer, and rising unemployment. The US economy is, by most indications, on the leading edge of a recession.

The biggest challenge to the economy remains the tight credit markets, which squeezed shut even more Friday after the collapse of Washington Mutual (WaMu), the largest bank to fail in US history. That left economists buzzing about an economic downturn that might be more severe than anything since the Great Depression of the 1930s – especially if Congress punted on the $700 billion rescue plan.

In the absence of a rescue deal for banks and other financial institutions, "we were going to have an extended recession with ... the potential for a depression," says Eugenio Aleman, an economist at Wells Fargo Banks in Minneapolis. "Even with the passage of the rescue plan, the slowdown is going to be long."

One major reason for a continued malaise is that it will take time for troubled banks to recapitalize, even if they unload bad loans on the US government.

"Unless the banks get new capital injections from the private sector, it will be very difficult for them to go out and lend" to businesses and consumers, says Mr. Aleman. If loans are not available for businesses to invest in themselves and for people to buy homes and cars and college educations, the economy as a whole can't grow.

J.P. Morgan Chase & Co., which late Thursday said it would acquire parts of WaMu from the government for $1.9 billion, did manage immediately to raise $10 billion from investors to replenish its capital base. J.P. Morgan said it will write off some $31 billion in bad WaMu real estate loans.

Most banks, however, won't be able to raise money so quickly, says Aleman. "It will take two, three, four years," he says. "But it will be easier to do it if they can get the bad loans off the balance sheet."

Some economists now expect the economic slowdown to continue into 2009. "The problems in the credit market will stretch this out," says Gregory Miller, chief economist at SunTrust Banks in Atlanta.

He anticipates that the downturn will last until April or May. "And, once we recover, it will be modest," he adds. "If I am wrong, it could last longer."

In fact, uncertainty surrounds the government plan as well as the economic forecast.

"If the government had not acted, we don't know what would have happened," says James Barth, a senior finance fellow at the Milken Institute in Santa Monica, Calif. "We are told that if the government hadn't stepped in to help J.P. Morgan buy Bear Stearns, there would have been all kinds of terrible things happening. Look at J.P. Morgan, immediately raising $10 billion – that tells us there are funds out there that are not necessarily coming from the government."

This is not the first banking crisis involving the US government. The last financial fiasco was in the 1980s, when the savings and loan industry slid into insolvency. Some 4,000 institutions failed over 10 years. Finally, the government-backed Resolution Trust Co. took over the institutions and sold their assets over five years.

The demise of the S&Ls, however, did not drive the economy into a recession, says Mr. Barth, chief economist at the Federal Home Loan Bank Board and the Office of Thrift Supervision during the presidencies of Ronald Reagan and George H.W. Bush.

"No one shut off the credit spigots, nor was there a widespread liquidity crisis," he recalls. "A major reason is that a lot of mortgage loans were not securitized and sold in the capital markets [back then], so the problem was contained in one industry."

Now the Federal Deposit Insurance Co., which insures bank deposits, has a list of 117 financial institutions, with a collective $70 billion to $80 billion in assets, that may need to be closed down. That list, however, did not include WaMu, says Barth. "Then, it would have been close to $400 billion in assets, and that would have frightened people."

The list also does not include Wachovia, which reportedly sought a merger partner last week after its stock fell 27 percent. The North Carolina bank has $120 billion in option adjustable rate mortgages, which are performing less and less well as the economy softens. Option ARMs allow borrowers to decide on their own whether to make a payment on their mortgage or just increase the size of the loan. The problem for such borrowers is that as their homes decline in value, their mortgage is still rising.

Although many economists say the congressional plan is needed to save the economy from an even worse downturn, Doug Elmendorf, a senior fellow at the Brookings Institution in Washington, says it will be awhile before anyone knows if the rescue deal does the job. "It's a lot of steps in the right direction, but whether it's enough, I just can't judge."

In the short term, the economic numbers are expected to get worse. This Friday, the government will release the September unemployment information, and few economists are optimistic.

Since the beginning of the year, the US has been losing about 80,000 jobs a month. More recently there are signs the unemployment rate might be starting to climb as the number of Americans filing new unemployment claims rise.

"We are probably going to ramp up the job loss to a rate of about 125,000 per month perhaps through the first or second quarter of next year," estimates Mr. Miller of Sun Trust Bank. "By the fourth quarter, the unemployment rate could be 6.75 or 6.8 percent with some 3.1 million people unemployed."

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