Friday, February 29, 2008

Federal Reserve Chairman Ben S. Bernanke yesterday said for the first time that he expects some bank failures as a result of the spreading financial crisis, while consumers as well as banks will bear the brunt of what could be a protracted economic downturn.

Mr. Bernanke’s testimony before the Senate Banking, Housing and Urban Affairs Committee provided his gloomiest assessment of the economy to date and came after the government reported that economic growth approached zero at the end of last year. While maintaining the Fed’s official stance that recession can be avoided, Mr. Bernanke discussed the possibility frankly and at length with senators.

President Bush yesterday said the economy is plagued by uncertainty but is still growing after posting growth of only 0.6 percent in the fourth quarter. “The housing issue is one that we’re deeply concerned about,” he said, adding, “We’ll make it through this period.”

The advent of bank failures is one measure of how deep the downturn has become. The country has not seen widespread bank failures since the savings and loan crisis of the late 1980s, which precipitated an expensive taxpayer-financed bailout, a major credit crunch and a deep recession in 1990 and 1991.

Mr. Bernanke expressed confidence there would be no bank failures as recently as last week, so his change of tune yesterday suggests that he recently became aware of banks whose solvency is threatened by what he characterized as a widening credit “crisis.”

“There probably will be some bank failures,” he said, though they are likely to be among smaller regional banks that are particularly exposed to falling property markets.

Wall Street markets, which swooned on Mr. Bernanke’s remarks about banks yesterday, have focused on the health of the biggest banks and investment houses, such as Citicorp, J.P. Morgan, Bank of America and Merrill Lynch, which cumulatively have reported more than $150 billion in losses. Despite their monumental troubles, Mr. Bernanke said he thinks the large banks have enough reserves and capital to avoid failure.

“I don’t anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system,” he said.

The large banks owe their relative strength in part to sovereign wealth funds controlled by foreign countries like Qatar and China, which have provided about half of the $75 billion in cash infusions the banks have sought to shore up their finances since last fall, Mr. Bernanke said, calling the foreign assistance “constructive.”

Small banks do not attract much foreign capital, and thus are more vulnerable to failing because of their growing mortgage-related losses. Some private bank analysts warned that growing property-related losses could catalyze a taxpayer-financed bailout of bank depositors costing as much as $400 billion to $500 billion.

While Mr. Bernanke said a bailout of large banks is unlikely, the Federal Deposit Insurance Corp. (FDIC) has been preparing for that possibility for months, issuing rules it would follow in case of a large bank failure and accruing staff for an onslaught of insolvencies. The FDIC is the agency charged with taking over failed banks, reimbursing insured depositors and liquidating the banks’ assets.

Beyond the bank question, Mr. Bernanke provided a sober assessment, saying the economy is in worse condition today than it was at the start of the 2001 recession.

Unlike in 2001, the Fed’s task of reviving the economy is “complicated” by rising inflation driven by soaring prices for oil, corn, soybeans, wheat and other internationally traded commodities, he said. The price of oil has skyrocketed from $20 in 2001 to more than $102 yesterday.

Also in 2001, the federal government had large budget surpluses it was able to deploy through tax cuts and increased spending to support the economy. Today, it is weighed down with large deficits and huge looming liabilities as the baby-boom generation retires, he said.

Most importantly, he said, the biggest burden during the 2001 recession was borne by technology businesses and stock investors who overinvested in tech stocks, he said, while the “brunt” of today’s downturn is being borne by American consumers.

Consumers are getting hit by high food and energy prices at the same time they are suffering the effects of a major credit crunch and plummeting house prices, Mr. Bernanke said. Regular gas prices have surged back above $3 a gallon while home prices are down 10 percent on average and much more in many major cities.

“The decline in home prices is creating a much broader set of issues, both for borrowers and homeowners, but also for the credit markets,” he said. “Consumers are taking the brunt of the effects.”

Mr. Bernanke said it will take time for banks and borrowers to resolve their debts. He said the economy might not see strong growth again for a few years. He said he is worried about a negative spiral developing if the economy falls into recession, causing even bigger drops in home prices and deepening defaults, foreclosures and losses for consumers and banks.

While acknowledging that high commodity prices represent an inflation threat that is beyond the Fed’s control and could be exacerbated by slashing interest rates, Mr. Bernanke dismissed charges that the Fed’s loose money policies could usher in “stagflation,” a combination of weak growth and high inflation.

Inflation rose to a 16-year high of 4.1 percent last year, but it remains far below the double-digit levels seen in the early 1980s. “I don’t think we’re anywhere near the situation that prevailed in the 1970s,” he said.

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