The economy

If you’re watching the news and scratching your head wondering what bomb hit the economy, you’re certainly not alone. It’s rough out there. People are losing their jobs, retirement dreams are going up in smoke and personal wealth is plummeting. Here’s why it’s happening and what it all means.

By now you likely know that the crisis in the financial markets is the culmination of years of reckless mortgage lending and Wall Street dealmaking. It’s the final gasp of the burst housing bubble. But how exactly did this happen?

To find the root cause of Wall Street’s woes, you have to go back to the collapse of a different bubble - tech. In 2001, after the dotcom craze ended and the bear market began, the Federal Reserve started aggressively slashing short-term interest rates to stave off recession. By eventually reducing rates to a historically low 1%, the Fed reinflated the economy. But this cheap money sparked a new wave of risk taking.

Homeowners, armed with easy credit, snapped up properties as if they were playing Monopoly. As prices soared, buyers were able to afford ever-larger properties only by taking out risky mortgages that lenders were happily approving with little documentation or money down.

At the same time, Wall Street investment banks got a brilliant idea: bundle the riskiest of these mortgages, then slice and dice these portfolios into tradable bonds to be sold to other banks and investors. Amazingly, bond-rating agencies slapped their highest ratings on the “best” of this debt.

This house of cards came down when subprime borrowers began defaulting on their mortgages. That sent housing prices tumbling, unleashing a domino effect on mortgage-backed securities. Banks and brokerages that had borrowed money to boost the impact of those investments had to race to raise capital.

Some, like Merrill Lynch, were forced to sell. Others, like Lehman Brothers, weren’t so lucky. “What we always tell investors is beware of too much leverage in a company,” says Brian Rogers, chairman and portfolio manager for T. Rowe Price. “Leverage is the enemy of the investor.”

Sure, everyone from former Fed chairman Alan Greenspan to your friends and neighbors played a role in stoking this casino culture. But troubled banks and brokerages can’t pass the blame. “These firms closed their eyes and made very bad bets on risky securities that they didn’t truly understand,” says Jeremy Siegel, finance professor at the University of Pennsylvania’s Wharton business school. “Investments that they did not have to make led to their demise.”

Before the meltdown, economists fell into two camps: those who thought the economy had already slipped into recession and those who thought a recession could still be avoided.

While forecasters still differ on the timing and severity of a downturn, “the consensus view is that we’re headed for recession and will be in one until next year,” says Mark Zandi, chief economist for Moody’s Economy.com.

Corporate profits are already on the verge of falling for a fifth straight quarter, according to Thomson Financial. The next shoe to drop will be consumer spending. “Two years ago, people were using their homes as ATMs, pumping out cash,” says Robert Arnott, chairman of the investment consulting firm Research Affiliates in Pasadena. “As banks continue to tighten their lending, that spending is disappearing.”

But softer profits and slower spending haven’t translated into widespread layoffs yet. “This is the strongest recessionary job market in 40 years,” says James Paulsen, chief investment strategist of Wells Capital Management. A jump in unemployment could still be coming, especially given bank and brokerage failures and mergers. But outside of finance and housing, much of the rest of the economy is strong, he says.

The weak dollar is boosting demand for our goods abroad, and lower gas prices are making Americans feel more flush. Add in the cash that the Fed has been hosing into the banking system and we are bound to see growth in 2009. “If all this stimulus has no effect on the economy, that would be a rarity indeed,” says Paulsen.

Standard & Poor’s chief economist David Wyss expects a mild recession that ends next spring. “Gradually we will regain confidence in the market. Lower oil prices and a falling trade deficit will help,” he says. “This is a financial panic, not an economic one.”

Of course, that could change if the financial panic doesn’t abate soon. If banks remain too scared or broke to lend, would-be home buyers will be frozen out of the market. If that happens, home values could fall even more, crimping confidence and putting the brakes on the economy’s greatest engine: the consumer.

Yes. “Taxes will rise regardless of who wins the Presidency,” predicts Greg Valliere, chief political strategist for Stanford Group Co.

It’s impossible to say what the final bill for rescuing Wall Street will be. Even before the bill to buy $700 billion of unwanted mortgage-backed debt, the government had already signed on for nearly $365 billion in loan guarantees and other costs.

The eventual price tag will depend in part on the housing market. If it recovers by 2010, the value of mortgage-backed securities could rise, minimizing the tab for taxpayers, says Brian Bethune, chief U.S. financial economist for Global Insight.

“On the other hand,” Bethune adds, “if the economy continues to tank into a deeper recession, dragging the housing market along with it, then the costs to the taxpayers easily could escalate to several hundred billions of dollars.”

Under Treasury Secretary Henry Paulson’s original debt-buyback proposal, some economists predicted the federal deficit could soar to $900 billion in 2009. Even without a bailout, the federal budget was expected to hit $482 billion next year. If government aid pads that figure by $200 billion, the deficit will be back to where it stood in the 1980s - around 5% of GDP. At the very least, that will make it hard for a future President to keep tax-cut promises.

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