Will Wall St. Woes Lead to Recession?

The Associated Press
Friday, August 17, 2007; 6:09 AM

WASHINGTON -- The stock market is on a stomach-churning ride, the nation's once high-flying housing market is sinking deeper into gloom, and credit, the lifeblood of the economy, is drying up. If consumers get nervous enough, many economists believe, all of these troubles could become the perfect storm that will plunge the country into a recession.

And the odds seem to be increasing with every new turbulent day on Wall Street. Since setting a record close of 14,000.41 just a month ago, the Dow Jones industrial average has shed 1,154.63 points in a string of triple-digit losing days that have raised anxiety levels not just on Wall Street but on Main Street.

The markets have been pummeled by a rapidly spreading credit crisis that began with rising defaults in subprime mortgages _ home loans made to people with weak credit histories. Now the problems are spreading to other borrowers.

Countrywide Financial Corp., the nation's largest mortgage banker, was forced to borrow $11.5 billion on Thursday so it could keep making home loans. It was a move that rattled investors who have watched a number of smaller mortgage companies go under because of credit problems.

The shockwaves have extended to giant Wall Street investment firms such as Goldman Sachs, which announced earlier this week that it was pumping $2 billion into one of its struggling hedge funds. BNP Paribas, France's largest bank, last week froze three funds that had invested in the troubled U.S. mortgage market.

The Federal Reserve and other central banks, responding to the widening credit problems, have infused the banking system with billions of dollars in an effort to keep short-term interest rates from surging and making credit even more difficult to obtain.

However, those billions have not succeeded in calming investors who are worried about which big hedge fund or mortgage company will be the next to announce serious problems. For that reason, investors have become fearful to supply money through credit markets to companies even if they have strong credit records.

"There is just a lot of fear out there," said David Wyss, chief economist at Standard & Poor's in New York. "Right now people are so scared that we are losing liquidity even on safe securities."

The credit crunch and market turmoil have increased the chances of a recession, many economists believe, from about one in six just a few weeks ago to one in three now.

"The risks of a recession have risen considerably and they will keep rising with each day that financial markets remain in turmoil," said Mark Zandi, chief economist at Moody's Economy.com.

The concern is that not only non-conforming mortgages, those that don't meet the standards set by Freddie Mac and Fannie Mae, will become hard to obtain but money for regular conventional mortgages will be tough to find as well. And the credit crunch could also spread to other types of consumer loans such as auto loans and credit card debt.

Since consumer spending accounts for two-thirds of the gross domestic product, the economy could quickly loose altitude if consumers find it more difficult to borrow the money they need to buy cars, appliances and clothes.

There is also a fear that the credit crunch could harm business borrowing, forcing companies to scale back on their plans to expand their operations, resulting in job layoffs throughout the economy, not just in the construction industry, which has already been struggling with the slowdown in housing.

The unemployment rate ticked up a notch to 4.6 percent in July and many economists believe it will hit 5 percent this winter, a figure that could go higher if economic growth suffers more than is now expected.

Rising unemployment would represent another blow to consumer confidence, which is likely to be rattled by the recent troubles on Wall Street. Worried consumers tend to grow more cautious and spend less, yet another blow.

Housing, where all the troubles started, will continue to be the hardest hit sector. The government reported Thursday that new home construction fell in July to the lowest level in a decade. Economists believe that the housing slump, already the worst in 16 years, will deepen in coming months, trimming economic growth further.

The economy, which had rebounded to growth of 3.4 percent in the April-June quarter, is likely to slow to below 2 percent in coming quarters, analysts at Global Insight are forecasting.

Growth at such subpar levels raises the risk that some unforeseen event, such as a further spike in energy prices, or more financial market turbulence, could push the country into a full-blown recession.

By one rule of thumb, a recession is defined as two consecutive quarters of declining economic output as measured by the gross domestic product.

While those are the threats economists see, they also believe the government has the power to stave off a downturn. Many believe the Fed should move not just to supply temporary reserves to the banking system, which it is doing now, but to cut interest rates, something Fed Chairman Ben Bernanke and his colleagues have so far been reluctant to do because of concerns about inflation.

However, reports this week showed prices outside of energy at both the wholesale and retail level were well-behaved, an indication that the Fed may now have the leeway to cut rates.

President Bush, whose approval rating for his handling of the economy was at 41 percent in August, according to the latest AP-Ipsos poll, near the low-point for his presidency, tried last week to calm market fears. After meeting with his economic team, Bush told reporters that he believed financial markets would be able to achieve a "soft landing."

Treasury Secretary Henry Paulson said in an interview Thursday in The Wall Street Journal that while the turmoil "will extract a penalty on the growth rate" he believed the country will be able to avoid a recession.

Republicans seeking to hold onto the White House in next year's presidential contest certainly hope that forecast comes true.

"If the country goes into a recession now, it means the economy will still be flat on its back next year before voters go to the polls," said Lyle Gramley, senior adviser at Schwab Washington Research Group. "I don't think the administration wants that."

© 2007 The Associated Press