Without a bailout, what happens next?

Congress’s rejection of a financial rescue package has sent a message to the financial community: You are on your own.

What will that mean for the US economy if Congress does not reconsider and vote for a bank rescue plan in the next few days?

Some economists predict that the credit markets will become so tight that businesses, unable to finance their operations, will have to start to lay off workers in two to three months. Others say the US may be on the road to a nationalization of the banks as yet more financial institutions go under. And some suggest that the Federal Reserve will do everything from massive infusions of liquidity to lowering interest rates to try to prevent a total collapse of the nation’s financial fabric. But many economists admit that no one really knows the answer since this is uncharted economic territory.

“To say we are in uncharted territory is a huge understatement,” says Joel Naroff of Naroff Economic Advisors in Holland, Pa.

The uncertainty has been reflected almost immediately on Wall Street where the Dow Jones Industrial Average quickly shot up more than 200 points at Tuesday’s opening after falling more than 777 points on Monday.

Without any bailout package from Congress, the Federal Reserve remains the main player. On Monday it lined up $600 billion in liquidity with other central banks. “It had to start to provide more liquidity especially at quarter end,” says Scott Brown of Raymond James & Associates in St. Petersburg, Fla.

Despite the Fed’s actions, short-term interest rates in London remained higher than normal and two percentage points above super safe three-month Treasury bills, a huge gap. “It is just indicative of the extreme strain in the credit markets,” says Mr. Brown.

However, the Fed has little choice but to remain active in the markets.

“What they can do is keep injecting money into the system,” says Doug Roberts, director of research at Channel Capital Research in Shrewsbury, N.J.
“That will keep everything moving but not fix the machine.”

However, some analysts say this will only keep the banking system from going under. It will not convince the banks to become more liberal with their loans. “Right now, the credit markets remain frozen and business will start to run out of cash soon and layoffs can begin in the next two to three months,” says Mark Zandi, a forecaster at Moody’s Economy.com in West Chester, Pa.

Already, the deepening of the credit crisis in recent weeks has prompted him to mark down his forecast for jobs and economic growth. He estimates that 450,000 more jobs will be lost in the US, above his “pre-panic” forecast of an 800,000-job decline during a recession that, by his reckoning, began late last year.

Mr. Roberts says one of his main concerns is that the rescue bill that was defeated in Congress “underestimates” the true costs. “This is a global problem, not a domestic problem,” he says. “The banks in Europe are having liquidity problems and we are counterparties to many of them.... Ultimately, we are going to have to come to grips with this.”

Roberts thinks one solution might be to nationalize the banks. “That is basically what happened when Continental Illinois went under [in May 1984]; the government took the bank over,” he says. “They can’t let the banks fail.”

However, even with Citigroup announcing it would buy parts of Wachovia on Monday, other banks remained weak, including National City Corp. in Cleveland and Sovereign Bank in Philadelphia. “I guess Congress is saying, ‘Show me the lack of money,’ ” says Mr. Naroff. “The problem is once they start seeing it, it’s too late.”

Before the stock market opened Tuesday, President Bush, for the second consecutive day, implored Congress to pass the rescue plan. “Our economy is depending on decisive action from the government,” he said. “The sooner we address the problem, the sooner we can get back on the path of growth and job creation.”

Naroff says there are lots of very good strong financial institutions but most of them are relatively small. “They have only so much capacity to lend in this economy. So now the question for any large corporation that needs money is, where will it come from?”

At the root of the problem for the banks is the continuing decline in housing prices. Sale prices for existing single-family homes for July fell a record 16.3 percent compared with a year ago, according to Standard & Poor’s/Case-Shiller 20-city index. However, the pace of the declines has slowed over the last three months.

“There are signs of a slowdown in the rate of decline across the metro areas, but no evidence of a bottom,” says David Blitzer, chairman of the Index Committee at Standard & Poor’s, in a press release. “Little positive news can be found when cities like Las Vegas and Phoenix report annual declines as large as -29.9 percent and -29.3 percent, respectively, and all 20 cities are still in negative territory on a year-over-year basis.”