Fear mounts as loans dry up

Despite misgivings, many economists are starting to agree that some sort of bailout is essential

The words that have come out of Washington this week about the state of the American financial system have been frightening. So frightening that a skeptical Congress is seriously considering -- despite public outrage -- sending as much as $700 billion of taxpayer money to Wall Street.

As the Bush administration warns of dire consequences without the bailout, some accuse it of fear-mongering to gin up support for the plan. Still, many economists have bought the prognosis, even while arguing over the appropriate prescription, concluding that some form of intervention is required to dispel the fear paralyzing the financial system.

While the debate goes on in Washington, in many corporate offices, in company cafeterias, and around dining room tables, the financial lockdown is impinging on plans.

"Loans are basically frozen due to the credit crisis," said Vicki Sanger, who is now leaning on personal credit cards bearing double-digit interest rates to finance building roads and sidewalks for a residential real estate development in Fruita, Colo. "The banks just are not lending."

With the economy already suffering the strains of plunging housing prices, growing joblessness and the new-found austerity of debt-saturated consumers, many experts fear the unraveling of the financial system could pin the nation in distress for years.

Without a mechanism to shed the bad loans on their books, financial institutions may continue to hoard their dollars and starve the economy of capital. That would slow economic activity further, souring more loans, and making banks tighter still -- a downward spiral.

"Without trust and confidence, business can't go on, and we can easily fall into a deeper recession and eventually a depression," said Andrew Lo, a finance professor at MIT's Sloan School of Management.

The Bush administration has hit this message relentlessly. Treasury Secretary Henry Paulson Jr. warned of a potential financial seizure without a swift bailout. Federal Reserve Chairman Ben Bernanke spoke of a "grave threat." In a prime-time television address Wednesday night, President Bush put it this way: "Our entire economy is in danger."

The considerable pushback to the bailout reflects discomfort with the people sounding the alarm. In the aftermath of the Iraq war, Bush carries a reputation in some quarters as someone who warns of deadly threats -- real or not -- when it suits his agenda. Paulson, a creature of Wall Street, asked Congress for extraordinary powers to take bad loans off the hands of major financial institutions with a proposal that ran all of three pages.

"The situation is like that movie trailer where a guy with a deep, scary voice says, 'In a world where credit markets are frozen, where banks refuse to lend to each other at any price, only one man, with one plan can save us,"' said Jared Bernstein, senior economist at the labor-oriented Economic Policy Institute in Washington.

Bernstein never bought the method. And yet, the more he looked at the data, the more he became convinced the economy was indeed in peril. "Things are scary," he said.

Suddenly, people who have spent their careers arguing that government is in the way of progress -- that its role must be pared to allow market forces to flourish -- are calling for the biggest government bailout in American history.

"We are in a very serious place," said William W. Beach, an economist at the conservative Heritage Foundation in Washington. "There is risk of contagion to the entire economy."

Even before the stunning events of recent weeks -- as the government took over the mortgage giants Fannie Mae and Freddie Mac, Lehman Brothers disintegrated into bankruptcy, and American International Group was saved by an $85 billion government bailout -- credit was tight, sowing fears that the economy would suffer.

The demise of those prominent institutions and anxiety over what could happen next has amplified worries considerably.

"The problem is so big that if somebody doesn't step in, it will cause a panic," said Michael Moebs, an economist and chief executive of Moebs Services, an independent research company in Lake Bluff, Ill. "Things could worsen to the point that we could see double-digit unemployment."

This week, Moebs said he heard from two clients, one a bank and the other a credit union in a small city in the Midwest, now in serious trouble: Both are heavily invested in Lehman Brothers, Fannie Mae and Freddie Mac.

"One is going to lose about 80 percent of their capital if they can't cash those in, and the other is going to lose about half," Moebs said.

The credit union is in a city in which the auto industry is a major employer -- an industry laying off workers. Yet as people try to refinance mortgages to hang on to homes and extend credit cards to pay for gas for their job searches, the local credit union is saying no.

"They have become very restrictive on who they are lending to," Moebs said. "They can't afford a loss. Their risk quotient is next to zero. You have a financial institution that really can't help out the local people who are having financial difficulties."