1 hurdle down, many more to go for the economy

— -- The extraordinary $700 billion financial rescue plan that President Bush signed into law Friday will begin the process of healing a battered financial system. But it's only the start of a journey that grows longer and more difficult with every turn in the road.

"This measure is an important step, but there is a possibility it may not be enough," says Frederic Mishkin, a former Federal Reserve Board governor.

The Emergency Economic Stabilization Act makes the Treasury Department the buyer of last resort for unwanted assets sullying financial institution balance sheets. The aim is to take the investment debris off the banks' hands, thereby freeing them to resume normal lending.

To free-market purists, it's an unpalatable step. But the need for action is unmistakable. Last week, credit channels were so impaired that even blue-chip companies such as General Electric found it difficult or unusually costly to raise short-term cash. Even the legislation's supporters acknowledge it isn't a cure-all for what ails the American economy. Too much damage has been done, and growth is likely to be either non-existent or anemic until 2010.

Despite widespread unease over the use of taxpayer money to salve Wall Street's wounds, it also seems virtually certain that lawmakers will in coming months confront anew demands for even greater government activism. Critics say the new federal legislation just won't do enough to resolve the banks' chief problem: a crippling shortage of capital.

Already, prominent economists across the political spectrum are floating proposals that envision mammoth government spending beyond the $700 billion bailout. Among them: shuttering insolvent banks and providing taxpayer cash to those that can be saved; a temporary unlimited government guarantee of all bank deposits; or even direct financial aid to individual homeowners to ward off foreclosure.

"This act alone is not really going to resolve anything. Eventually, the government is going to have to do more," says George Magnus, senior economic adviser to UBS in London.

As the Treasury Department prepares for its first purchases of troubled assets, the economic outlook is darkening appreciably. Employers cut 159,000 jobs in September, the ninth consecutive month of payroll shrinkage, the Bureau of Labor Statistics said Friday. So far this year, the economy has shed 760,000 jobs — more than the population of El Paso.

That news came one day after the Commerce Department said factory orders fell by an unexpectedly large 4% in August. And that, in turn, followed word that consumer spending had flatlined. The drumbeat of bad news persuaded Morgan Stanley to lower its estimate of third-quarter gross domestic product and predict the economy had shrunk by 0.6% for the three months just ended.

"We're in a recession," said Kenneth Rogoff, former chief economist for the International Monetary Fund. He is among those predicting that the economy won't resume even mild growth until 2010.

More expect Fed rate cut

All that negative news made it clear the economy was in distress even before the credit markets seized up two weeks ago. The accelerating decline is stoking expectations that the Federal Reserve will cut interest rates, perhaps by half a percentage point, this month. The Fed next meets Oct. 28, but it doesn't have to wait that long to act.

If a new IMF study can be believed, the U.S. has a long way to go before it puts the current episode behind it. Researchers examined 113 periods of "financial stress" in 17 advanced economies over the past three decades, comparing those that involved widespread banking-sector problems — like the current U.S. crisis — with those involving only financial markets dips.

Unsustainable housing price increases, massive expansion of credit, and heavy borrowing by consumers and businesses tend to exacerbate subsequent downturns. "Episodes of financial turmoil characterized by banking distress are more often associated with severe and protracted downturns," the study concluded. Compared with earlier crises — such as the collapse of Japan's 1980s bubble economy — "the current episode seems to have the widest impact," the IMF said.

The malady that the Treasury plan is aimed at alleviating was illustrated by word that frozen credit markets may drive the state of California to request a short-term federal loan of $7 billion.

Getting ready to buy

Officials from the Fed and Treasury already are mapping out plans to hire asset managers and begin making deals in four to six weeks. While the focus has been on mortgage-backed securities, the legislation gives Treasury broad power to purchase an array of financial assets.

Indeed, even as the House debated the $700 billion rescue Friday, Rep. John Dingell, D-Mich., urged the Fed to lend money to auto financing companies such as Detroit-based General Motors Acceptance Corp. Slowing car sales and credit market disruptions have battered GMAC for much of this year. In July, it blamed a $2.5 billion second-quarter loss in part on "continued volatility in the mortgage and credit markets."

Brian Bethune, a Global Insight economist, says prices for mortgage-backed securities that have been languishing without buyers "should rise immediately in secondary markets in anticipation of these purchases."

The good news is that a vast majority of mortgages are being paid on time and the owners of the related securities are collecting the interest payments, says James Sarni of investment firm Payden & Rygel. These securities have value, but buyers have been reluctant to bid on them because they're afraid another troubled financial institution may try to raise cash by dumping similar securities on the market. That would depress values for all.

Now, knowing that the government has the resources to hold the securities and sell in an orderly way, buyers will be more willing to buy. "It's like oil has been injected into a motor that's rusted," he says.

Tentative signs of progress could be seen Friday in the bond market. One measure of how worried bond investors are about getting their money back from U.S. companies with the highest credit ratings fell nearly 2% as investors grew more sanguine. Still, Credit Derivatives Research's CDR Investment Grade index remains elevated; it's up 7% the past week and up a staggering 289% this year.

Showing how reluctant investors are to lend, debt securities of the most highly rated U.S. companies Friday set a record yield at 4.91 percentage points more than Treasury securities with similar maturities, according to the Merrill Lynch U.S. Corporate index. A year ago, it was 1.48 percentage points.

Just a beginning

So even with the rescue plan, the U.S. has a long road to travel before it reaches financial normalcy. House Democratic leaders plan hearings in coming weeks to examine how the markets got into this mess. House Financial Services Committee Chairman Barney Frank, D-Mass., says Congress next year will have to write some of the most important financial legislation since the Depression.

Until then, shell-shocked investors will be left to ponder an essential truth, says Marc Chandler, senior vice president at Brown Bros. Harriman. "The power of the U.S. government either can resolve this crisis," he says, "or it can't."