When faith is frayed

In a modern financial system, nothing is more frightening than a run on the bank.

The U.S. now has suffered through a series of them, and they are escalating in size and scope -- posing a serious threat to the already reeling economy.

On Friday, rumors swamped financial markets that the federal government would be forced to step in to aid mortgage-finance giants Fannie Mae and Freddie Mac, which together own or guarantee $5 trillion in U.S. home loans.

In Wall Street's version of a bank run, investors drove shares of Fannie Mae and Freddie Mac to 17-year lows, signaling a gnawing lack of faith in the companies' ability to survive rising mortgage defaults without government help.

Later in the day, regulators took over IndyMac Bank of Pasadena, saying the $32-billion lender had collapsed under the weight of bad home loans and withdrawals by spooked depositors. It was the second-largest bank failure in U.S. history.

Friday's events were felt around the world, knocking the battered U.S. dollar lower and driving up interest rates.

"This is a flare-up in the financial forest fire that is far beyond anything we've seen before," said Christopher Low, chief economist at investment firm FTN Financial in New York.

And it is triggering worries that would have been unthinkable even a year ago -- including that the U.S. Treasury's debt might lose its AAA credit grade because of heavy blows to the nation's fiscal health from the housing mess.

Just four months ago, many on Wall Street believed they had seen the worst of the credit crisis rooted in the housing market's woes. The collapse in March of brokerage Bear Stearns Cos., a key player in the business of packaging dicey mortgages for sale to investors, was the kind of high-profile calamity that historically has marked the end of financial crises.

Bear Stearns, too, was a victim of a devastating run on the bank, as many of its creditors suddenly stopped lending to the firm and investors dumped the company's stock.

Reacting quickly, the Federal Reserve took unprecedented steps after Bear Stearns' demise to make cheap loans available to loss-ridden banks and, for the first time, to securities firms. The Fed's moves helped restore calm to markets by April.

But by May, investors' focus had returned to the slumping housing market and the likelihood that banks and brokerages would face more losses on mortgage-related debt. Confidence in the stock market, and in financial institutions large and small, eroded anew.