Government Leaders Reassure but Dow Drops

July 15, 2008 — -- As President Bush sought to reassure Americans about the state of the economy, the Federal Reserve chairman today painted a considerably bleaker picture and the U.S. treasury secretary urged Congress to pass a mortgage assistance plan that, thus far, has no price tag.

Bush, speaking at a White House news conference this morning, said that the nation's financial system is "basically sound."

"I understand there's a lot of nervousness, but the economy is growing," the president said. "Productivity is high. Trade's up. People are working — it's not as good as we'd like. And to the extent that we'll find weakness, we'll move."

Bush's comments didn't bolster stocks today. The Dow Jones Industrial Average closed down more than 90 points, falling below 11,000 for the first time since July 21, 2006.

Earlier in the day, Federal Reserve Chairman Bernanke conceded before the Senate committee that the economy continues to flounder and inflation continues to grow despite steps taken by the Fed to shore up financial institutions and encourage spending.

The Fed's decision to allow investment banks access to low-interest loans and its repeated cuts to the key federal funds rate "have had positive effects," Bernanke said in testimony before the Senate Banking, Housing and Urban Affairs Committee.

But, he said, "the economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food and some other commodities."

Bernanke's testimony comes as investors and consumers grapple with a glut of discouraging economic news. In recent days, shares of Fannie Mae and Freddie Mac plummeted as investors reacted to concerns that the government-sponsored companies may not have enough capital to cover losses stemming from the nation's ailing mortgage market.

The government's assurances Sunday night that the Federal Reserve and the Treasury Department would lend money to Fannie and Freddie, if necessary, did not stop the stocks' declines.

Other financial institutions have also suffered: California-based IndyMac's failed mortgage business forced government regulators to shut down the bank Friday. This week, share values for Washington Mutual, Wachovia and other banks saw double-digit percentage drops as Wall Street steeled itself for bank earnings reports due later this week.

Broader economic indicators offered no relief: The Labor Department reported this morning that wholesale prices in particular, skyrocketing prices for gas and food registered a 9.2 percent increase in the past 12 months, the largest jump in 27 years. Meanwhile, retail sales grew by only 1 percent, a weaker-than-expected result largely attributed to a 3.3 percent decline in sales at auto dealerships, according to the Commerce Department.

Bernanke said inflation would likely continue to move higher, temporarily, due to rising energy prices.

The overall high rate of inflation, he said, was due to the run-up in prices in oil and also other commodities, such as metals and certain crops. The Fed's "best judgment," he said, was that growing worldwide demand was responsible for the sharp rise in oil prices. The decline in the value of the dollar, he said, has "contributed somewhat" to the increase.

Bernanke said that the economy "has continued to expand, but at a subdued pace," noting that the number of U.S. jobs fell by an average of 94,000 per month since the start of the year and that sales of new homes and home prices have continued to the fall. Personal spending, he said, "held up somewhat better than might have been expected," given the stagnant salaries, falling consumer confidence and the tight credit conditions in the United States.

With respect to the mortgage crisis, Bernanke said that new rules recently approved by the Fed that, among other requirements, would require lenders to check a borrower's ability to repay a loan "will help to restore confidence in the mortgage market."

The rules, he said, "will establish lending standards aimed at curbing abuses while preserving responsible subprime lending and sustainable homeownership."

Bernanke and the Fed faced intense criticism from Sen. Tim Bunning, R-Ky.

The senator argued that the Fed had waited too long to regulate mortgage lenders and said that the agency could not be trusted with more power.

"Giving the Fed more power is like giving the neighborhood kid who broke your window playing baseball in the street a bigger bat and thinking that will fix the problem," he said.

Bunning also criticized the Treasury Department's proposal to lend unspecified amounts of money and make equity investments in Fannie Mae and Freddie Mac, if necessary.

The senator said that when he learned of the proposal, he thought he was in France.

"The Treasury Secretary is asking for a blank check to buy as much Fannie and Freddie debt or equity as he wants," Bunning said. "The Fed's purchase of Bear Stearns' assets was amateur socialism compared to this."

But U.S. Treasury Secretary Henry Paulson, who joined Bernanke in testifying before Congress today, said in his late-morning remarks that it was important not to set limits on how much the Treasury can offer when it comes to lending and investing in Fannie and Freddie. Keeping the amount of its aid unspecified, he said, might reduce the chances that the Treasury's aid will be necessary.

"If you're used to thinking about the issues, it is very intuitive that if you've got a squirt gun in your pocket, you may have to take it out," he said. "If you've got a bazooka and people know you've got it, you may not have to take it out, you're not likely to take it out.

"By having something that is unspecified," he continued, "it will increase confidence, and by increasing confidence it will greatly reduce the likelihood it will ever be used."

Paulson stressed that the Treasury Department had no immediate plans to lend to or invest in Fannie and Freddie.

"If either of these authorities is used, it would be done so only at Treasury's discretion, under terms and conditions that protect the U.S. taxpayer and are agreed to by both Treasury and the GSE (government-sponsored enterprise)," Paulson said.

The SEC is also taking steps to protect Fannie Mae and Freddie Mac. Securities and Exchange Commission Chairman Christopher Cox, who also testified before the Senate committee today, said that the SEC would limit more short sales — bets that a stock will fail — of Fannie Mae and Freddie Mac shares.