Crisis management: Can Congress and the Fed rescue the economy?

The Federal Open Market Committee voted 9-1 today to lower the rate at which banks lend to each other to 3 percent from 3.5 percent. Just eight days ago the Fed lowered that rate by three-quarters of a percent. Experts at the W. P. Carey School of Business see both peril and promise in the reactions of policymakers to Wall Street's wild ride. The turmoil in credit markets is uncharted territory, and it will take some time to determine the effectiveness of the actions taken.

The Federal Open Market Committee voted 9-1 today to lower the rate at which banks lend to each other to 3 percent from 3.5 percent. In its announcement, the Fed stated that "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets. The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully."

Just eight days ago, between scheduled meetings, the Fed decided to drop its key lending rate by three-quarters of a percent. Asian and European stock markets had been in free fall over the Martin Luther King holiday weekend, amid fears that a growing credit crisis in the United States would spark a recession that would spread across the globe.

The three-quarter percent drop was the largest interest rate cut in over two decades, launching U.S. stocks on a day-long roller coaster. The Dow Jones Industrial Average dipped 300 points early before finishing up 300 points and showing signs of hitting a plateau. Within 48 hours, Congress and the White House had reached a deal for a $150 billion stimulus package that would send $600 checks to millions of Americans.

Experts at the W. P. Carey School of Business see both peril and promise in the reactions of policymakers to Wall Street's wild ride. The turmoil in credit markets is uncharted territory, and it will take some time to determine how effective the actions taken last week will be, according to the economists.

"Sometimes the only way to stop a panic is to take everybody's mind off of it for a minute, to get them focused on something else," says Tracy Clark, associate director of the JPMorgan Chase Economic Outlook Center. "And that's what the Federal Reserve did. They basically stood up, whacked people upside the head and said, 'We're paying attention. Don't panic.' So far it seems to be working."

Finance Professor Herbert Kaufman believes the steps taken by the Federal Reserve, Congress, and President Bush will help the economy, but not enough to avoid a recession. "What the Fed is doing and the stimulus package will mitigate how long it is and how deep it is but I don't believe we can avoid it now," he says.

Risky loans, widespread effects

Clark says it is difficult to know what will happen, because this crisis is unlike any other this country has seen. Real estate used to be a local phenomenon, he notes, with local builders getting construction loans from local bankers, who provided mortgages to local buyers. But this time, banks and other lenders packaged mortgages they had issued as "structured investment vehicles," which were sold in equity markets. And many of these loans, it was later determined, were exceedingly risky.

Once the problems in mortgage markets became known, they snowballed and spread, according to Clark. The first thing that happened was that money for mortgages disappeared. "If you stop the flow of money, then you stop the flow of mortgages, and housing prices start tumbling," Clark says.

Mortgage insurers and banks were hit hard almost immediately. Because mortgages were being traded in capital markets, stock markets were hit too. Foreign banks had purchased some of the U.S. mortgages, and they found themselves in trouble also. Soon the American consumer was affected. "If consumers can't refinance their mortgage, they can't keep buying, so consumer spending starts slowing down, and that involves another whole section of the economy," Clark says.

A rate cut brings concern and reassurance

While the Fed's initial rate cut appeared to stop the downward spiral, the long-term effects of the still unfolding mortgage crisis are unknown, according to Clark. The rates on many of the risky mortgages will not reset until later this year or in 2009 or 2010, he notes. "In that sense, we don't know how bad it's going to get because we haven't gone through the worst of it yet," he says.

Kaufman faults the Federal Reserve for not attacking interest rates sooner. "Starting in August, people could see that this was going to be not a trivial crisis," he says. "Last week's surprise rate cut with the Bush/Congress/government tax cut package being announced at the same time was a gamble because it could ignite more fear," says Dawn McLaren, research economist at the JPMorgan Chase Economic Outlook Center.

"It can be worrisome. People might look around and say, 'Eek!' These people must think something is really wrong." Robert Marquez, associate professor of finance, believes there was initial panic — evident in the 300-point drop — but then it gave way to a sense of reassurance. "The Fed also made it clear that it is there to try to ease the problems."

Stimulating the economy

The stimulus package being debated on Capitol Hill carries the possibility of boosting the economy while at the same time injecting new elements of risk, according to the W. P. Carey economists. One of the provisions of the initial proposal included lifting the cap on mortgages that lenders can package and sell to Fannie Mae and Freddie Mac from $417,000 to $729,750. Marquez says that while this may boost the mortgage market in the short term, it could create problems in the future by producing new high-risk loans.

"It has been the availability of loose credit and the ability to repackage mortgages that led to the housing problems in the first place," Marquez says. "A concern might be that as a result lenders continue to be too loose in extending credit." McLaren sees problems for some regions of the United States if an extension of unemployment benefits is omitted from the stimulus package. She notes that unemployment compensation allows people to stay where they are after they lose their jobs and develop new skills or wait for local conditions to improve.

Without unemployment benefits, they are more likely to pick up and leave, and this can hurt a region that is already in trouble. "When people are in an area and they're buying bread, they're creating jobs for bakers. You take them out of the economy and you get a worsened recession. Michigan, Ohio — the areas that have been losing jobs already — have depended on keeping people in the area," McLaren says.

Kaufman says the biggest problem with the stimulus package is that it is too late. He believes the U.S. economy may already be in recession — defined as two consecutive quarters of negative GDP growth — once the numbers for the last quarter of 2007 and the first one of 2008 are in. "By the time this takes effect in June, which could be the end of the third quarter of a recession, we could already be coming out of a recession," says Kaufman. "I think it's helpful but it's not an immediate fix."

An adjustable mortgage and a $600 check

McLaren believes that the rebates being discussed — around $500 or $600 for most taxpayers — are of little help to people caught in a mortgage trap. In parts of Arizona and elsewhere in the West, some $200,000 condominiums, purchased with little money down at the height of the boom, now are worth $120,000. "People are seeing their equity position drained away. What will a few hundred dollars do?" she asks.

According to Clark, the way that Congress and the president handle a stimulus bill could be as important as the details of the package. "They have to enact it quickly without a lot of infighting because the psychological impact will be greater. People will say, 'The government's really on the ball, they really are trying to help,'" Clark says. He agrees with McLaren that a one-time $600 check will not help someone whose adjustable rate mortgage is about to reset. "All it's intended to do is to have people spend more money," Clark says.

Bottom Line:

• The credit crisis in the United States resulted from risky loans being packaged and sold on equity markets. Because this has not happened before, the direction of the crisis and its effect on the rest of the economy is uncertain.
• Federal Reserve rate cuts sometimes have the effect of creating a sense of alarm about the economy, but at other times they reassure investors and the public that the central bank is prepared to act.
• Lifting the cap on the value of mortgages that lenders can sell to Fannie Mae and Freddie Mac could help ease mortgage markets, but the strategy carries a danger of creating more risky loans.
• Extending unemployment benefits can help a struggling regional economy by encouraging the out-of-work to stay in place while a region recovers.
• A $150 billion stimulus package may boost the economy, but it probably will do little to help homeowners whose property values have fallen and whose adjustable rate mortgages are about to go up.