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Rescue package aside, economy faces deep challenges

WASHINGTON — The congressional compromise drafted over the weekend to rescue Wall Street, assuming it wins approval, is expected to fend off a potential meltdown of financial markets for now. But it won't cure much of what ails the struggling U.S. economy.

Many economists believe the U.S. economy is in recession, or so close to it that it's almost an academic question. The weekend compromise in Congress doesn't fix that, but it prevents things from getting worse by calming the jittery credit markets, which are vital to the ability of corporate America to fund itself through issuance of short-term debt.

Finance is something that happens in the background, like the fan belt on an automobile's engine, a whirring that goes unnoticed over the sound of the road. Everything runs with the help of these credit markets, and when they stop working, as they did on Sept. 17, it gets attention quickly.

"People watch the stock market, but that is not the key here. The credit markets are the key," said David Wyss, chief economist for the rating agency Standard & Poors in New York.

In recent weeks, hotel and other big construction projects have ground to a halt as financing suddenly went dry, and automobile finance companies have suddenly found it hard to lend. Credit markets reflect an important intersection between Wall Street and Main Street.

If credit markets respond positively this week, the spread, or gap, between the interest on Treasury debt -- the safest place to lend money -- and other lending rates will narrow. This widening gap has hurt corporate America's ability to conduct needed short-term borrowing except at extremely high rates.

If this spread narrows, the problems of the past 10 days may be just a blip on the charts that make up a historical record of the American economy. If these markets remain in turmoil, there could be even more bank failures, and a fast accelerating economic slowdown.

"If history tells us one thing, it's that you cannot let these (modern-day) bank runs go on. You've got to stop it," said Wyss.

A principal risk now for the American economy is that the spate of bad news will feed on itself, creating a downward spiral.

For example, the wave of bank failures and mergers is sure to lead to large layoffs in the financial sector, and already computer makers like Dell and Hewlett Packard have announced job cuts in the expectation of a worsening sales environment.

As the number of jobless grows, the number of delinquent home loans grows larger. And defaults on car loans rise. More consumers will fall behind on credit card payments, restaurants will shutter their doors because of fewer diners, and fewer restaurants will cut demand for farm and processed food products. It's all inter-linked and becomes a spiral.

For the moment, the unemployment rate stands at 6.1 percent, a number that's expected to grow when the Labor Department provides the September jobless numbers on Friday. Today's unemployment rate is low by historical standards, but it is up by more than 2 percentage points since its low point in summer of 2006.

"All 10 previous occasions in the post-war era when the unemployment rate has risen so much have been associated with recessions," said Michael Mussa, a former director of research for International Monetary Fund, in a paper presented Friday on global economic prospects.

Given the sharp gap between the current and potential growth of the U.S. economy, Mussa said that for "practical purposes, this magnitude of an economic slowdown should probably be regarded as a recession - even if the exact timing of its starting and ending points are hard to specify."

Housing is front and center in the nation's economic problems and will be a determining factor for the speed and depth of recovery.

The rescue legislation will make available up to $700 billion in taxpayer money to remove bad mortgages and other distressed assets off the books of banks and financial firms. The reason for doing so is that accounting rules that took effect in 2007, put in place partly because of the spectacular 2001 collapse of energy giant Enron Corp. - force banks to provide a present-day value of these mortgage bonds every quarter.

Since housing continues to lose value month by month, banks have been going through wrenching write-downs of assets each quarter, forcing them to seek more capital. This is called mark-to-market accounting.

Instead of lending, banks are forced to raise capital in order to cover the widening losses on mortgage bonds that they are declaring quarterly.

Some economists like Mark Zandi, author of the new book Financial Shock, have called for a temporary suspension of these accounting rules since mortgage bonds have a hold-to-maturity value. That means these bonds will be worth more when the housing market rebounds than they do now, and this is why the treasury could make money over time on the rescue package.

"Current mark-to-market rules have exacerbated the crisis as financial institutions have been forced into a self-reinforcing negative cycle of asset price declines forcing write-downs and thus asset sales and further price declines," said Zandi, chief economist of forecaster Moody's "Mark-to-market accounting could be adjusted so that the marks are smoothed over time so that sharp price declines don't force big write-downs immediately."

The proposed rescue plan orders the Government Accountability Office to conduct a study of the current mark-to-market rules and make a recommendation. The plan also restates that the executive branch has the authority to suspend these rules.

Supporters of mark-to-market accounting suggest it is brutally transparent and will prevent the kind of hide-and-seek employed by Enron that brought about its collapse. Had mark-to-market rules been in place during the savings-and-loan crisis in the 1980's, there surely would have been more bank failures, said Mussa, the former IMF researcher now with the Peterson Institute for International Economics.

Once the government takes over the troubled mortgage assets, it will face the challenge of restoring faith in these mortgage bonds - technically called mortgage-backed securities.

That will prove challenging until home prices stabilize since the government will face the same problem that banks now face - the difficulty determining the real value of the mortgage bonds as home prices keep falling.

Mortgages pooled together are the underlying collateral of these bonds, and banks have been reluctant to refinance a lot of these troubled in loans in markets like California and Florida. That's because a home that originally carried a $700,000 mortgage is now worth $500,000 and could be worth $400,000 next year.

Treasury Secretary Paulson vows that in government hands, loan modifications will take place at a faster pace. This could serve to put a bottom in falling home prices and begin the housing recovery.

If that doesn't happen and home prices deteriorate further, taxpayers will be taking losses on loans reworked by the government.