Economy: Credit risks, housing market create uncertainty

U.S. exports have picked up, manufacturing has expanded and the strong commercial real estate sector has helped dull the losses from the housing plunge. World economic growth is booming.

"If it is a financial crisis, it's a great time to have one," says Jim Paulsen, chief investment officer of Wells Capital Management, who says the markets have overreacted. "We've got the business sector coming back; clearly, international trade is coming back, and so is manufacturing."

The Fed has given no sign that it plans to change interest rate policy in the near term due to stock and bond market gyrations. Fed Governor Randall Kroszner told the Senate Banking Committee on Thursday that economic fundamentals hadn't changed since mid-July, when the Fed released its outlook and called inflation its predominant concern.

Still, forecasters at financial firms such as JPMorgan jpm that had predicted the Fed would raise rates this year to attack inflation, are now backing off those forecasts and focusing more on slower growth. Futures markets contracts that predict Fed policy are giving higher odds of a rate cut later this year.

Mark Zandi of Moody's says the Fed could change the wording of its statement to indicate that inflation is no longer its main risk and cut rates later this year to help get the credit markets moving again.

"It's a rational repricing of risk, but when markets are repricing like this, they are extra vulnerable," Zandi says. "If anything goes wrong … you'll get a credit crunch."

A drag from housing

New-home sales are down 20% from last year, and Bernanke warned that housing will be a drag on the economy into next year, even if things start to turn around, given the large inventory of unsold homes to be worked through. Some builders think the pain could last longer than that.

"None of the large public (builders) are buying any land, there are more lots for sale and more land that's sitting," says Marsha Elliott, president of Terrestris Development in Chicago, a midsize home developer.

Elliott, who has been in business for three decades, calls this downturn the strangest she's seen in the sense that it's not pushed by fundamentals such as rising interest rates or a bad job market. She doesn't expect recovery for, "a couple of more years, at least. It's 'batten down the hatches.' "

Doug Duncan, chief economist of the Mortgage Bankers Association, says the problem isn't the cost of credit, but the availability of buyers in the secondary market for mortgage-backed securities due to perceived risk. Interest rates on high-quality mortgages have actually dropped in recent days, with some rates near 6.5%.

He expects the Fed to stand back a bit to gauge where housing is going, adding that a hasty rate move could be misinterpreted by markets. He now expects it will be "well out into 2008" before the housing fall hits bottom.

Andrew Chaban, CEO of Princeton Properties in Lowell, Mass., which owns and manages about 5,500 apartment units, says the real estate market in areas of the Northeast where he operates is holding its own — for careful projects.

"If you have taken more gambles … if you've overleveraged your property, you don't have enough equity in the deal, those are the types of deals we see being hurt," Chaban says.

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