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Why it feels worse than it looks

TOM PETRUNO / MARKET BEAT

July 19, 2008|TOM PETRUNO

Are things really that bad?

Is this the worst situation we've faced since the Great Depression?

Is there any way out?

Those questions must be asked thousands of times a day in private and public conversations about the financial system and the economy.

The Internet is filled with often bitter commentaries insisting that this time America has dug a hole from which there's no escape. That kind of talk is always out there, but it now is as pervasive as I've ever experienced in 30 years of writing about this kind of stuff.

It's also understandable given what the nation has suffered through over the last year: tumbling home prices, soaring mortgage defaults, the worst stock market decline since 2000-02 and record oil prices. The bad news has been nearly unrelenting.

This week saw yet another frightening crisis in the financial system, this one centered on fears about the fiscal health of mortgage titans Fannie Mae and Freddie Mac, and on the government's seizure of failed IndyMac Bank.

In mid-March, markets were upended by the collapse of one of Wall Street's oldest brokerages, Bear Stearns Cos. In early January, it was the rescue of Countrywide Financial Corp. by Bank of America Corp.

In the stock market, the verdict in the last few days was that this latest turmoil, too, would pass without destroying the system. The Dow Jones industrial average ended Friday at 11,496.57, rebounding 4.9% in three days after hitting a two-year low Tuesday.

But it took the government, once again, to rush in.

In March, the Federal Reserve arranged, and helped finance, the emergency takeover of Bear Stearns by JPMorgan Chase & Co. This time, the U.S. Treasury said it would invest taxpayer dollars in Fannie Mae and Freddie Mac if that's what is needed to keep them solvent -- given that they own or guarantee $5 trillion in home mortgages.

The Treasury's admission that it might have to nationalize Fannie Mae and Freddie Mac just gave more ammo to those who believe the economy is headed for certain ruin.

The nation's financial infrastructure is "crumbling before our very eyes," declared Peter Schiff, head of brokerage Euro Pacific Capital and author of "Crash Proof: How to Profit from the Coming Economic Collapse."

There are, of course, many cooler heads out there.

Bill Isaac, who was chairman of the Federal Deposit Insurance Corp. from 1981 to '85 and now heads bank consulting firm Secura Group, said that the government had contingency plans in the early 1980s for the nationalization of the biggest U.S. banks. That was when the banks were weighed down by the debt of Third World countries that could no longer pay their bills.

The system survived that scare. And it survived the failure of thousands of smaller banks and thrifts in the late-1980s and early 1990s as the commercial real estate market crashed, Isaac noted.

Bank failures are bound to rise this time, Isaac said. But he insisted there was "absolutely no" chance of repeating the level of failures of the 1980s.

As for the economy overall, it still hasn't weakened enough to fit the classic definition of a recession, which is two consecutive quarters of contraction in gross domestic product. Many analysts say the economy probably continued to expand in the second quarter, albeit at a very slow rate. The government's first estimate of second-quarter growth will be announced July 31.

Still, Federal Reserve Chairman Ben S. Bernanke this week told a congressional panel that he wasn't focused on official definitions. Asked whether he thought the nation was in recession, he said: "People are very worried, so I certainly would never make the claim that even if we were not in a technical recession, that it wasn't a serious situation."

Bernanke reads the same consumer-sentiment surveys as the rest of us. He knows that by some measures Americans' confidence in the future is lower than it was even in the mid-1970s, that horrid period of surging inflation and high unemployment.

And so the question keeps resurfacing: Are things really so bad now?

There may be a relatively simple explanation for why the mood is so grim, even if economic reality, so far, doesn't seem to match it. And the explanation has nothing to do with the idea that our memories may just be too short.

Consider this: Many of the financial-system crises of the post-war era were largely contained to Wall Street. Their effect on Main Street was limited. The 1987 stock market crash, for example, devastated the economy of New York City. But it barely rippled out to the rest of the country.

Today, the financial crisis that grips Wall Street began on Main Street, with the housing boom that has become an unprecedented bust.

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