Credit Crunch: The Sequel

It's the failure of a large bank that has the potential to really upend the financial system. Kenneth Rogoff, former chief economist at the International Monetary Fund, rattled markets in mid-August by suggesting that such an event could occur within months. Large banks and brokerages certainly face head winds. Goldman Sachs recently cut its earnings estimates for Lehman Brothers, Morgan Stanley, JPMorgan, Merrill Lynch, and Citigroup, saying that the pace of mortgage asset deterioration hasn't slowed.

But because big banks are so intertwined with the rest of the financial system, the government will not allow one to go under, says Bill Gross, chief investment officer at Pacific Investment Management. "The Bear Stearns situation proves that, at least at the moment, the big banks are too big to fail," he says. But a large regional bank might be allowed to go under, Gross adds. Weiss Research recently released a report that measured bank soundness by taking into account capitalization, asset quality, profitability, liquidity, and stability. It listed National City, Sovereign Bank, and Washington Mutual among the weakest. But that doesn't mean failure is imminent, cautions analyst Mike Larson of Weiss Research. Spokespersons for both National City and Sovereign say the banks have recently raised capital and are on solid footing. A Washington Mutual spokesman declined to comment.

Meanwhile, Fannie and Freddie are fighting for their lives. The companies, which Congress chartered to stabilize the mortgage market, buy home loans from lenders. They hold some of these mortgages in their portfolio and package others into securities for sale to investors. Fannie and Freddie became even more essential to the mortgage market as private-sector buyers vanished during the housing crisis. But with defaults increasing, Fannie and Freddie have been slammed with roughly $14 billion of combined losses over the past year. Paul Miller, an analyst at FBRCapital Markets, says each needs as much as $15 billion in fresh capital to weather the storm. With their stock prices plummeting—down more than 80 percent on the year—it's increasingly unlikely that private investors will pony up that kind of cash. And as bond investors demand higher yields on their debt, more and more economists and investors believe Treasury Secretary Paulson will have to deploy his recently acquired authority to bail out Fannie and Freddie. "The game is over," billionaire investor Warren Buffett told CNBC last month. If bond investors keep buying their debt, Fannie and Freddie might be able to avoid government intervention. But that's looking doubtful. With demand for its debt waning among Asian investors, Fannie was forced last month to pay a record-high interest rate to attract buyers.

Recession? Damage to individual firms is painful enough, but the credit crisis's potential to hammer the broader economy is even more unnerving. "It's the biggest concern that we have right now," says Mark Vitner, senior economist at Wachovia. "If we have a recession, it will likely result from the credit crunch." The impact of the squeeze already can be seen in consumer spending, which represents more than two thirds of the U.S. economy. With bad loans piling up, 80 percent of domestic banks said they had tightened lending standards for home-equity lines of credit between April and July, according to a Fed survey. Sixty-five percent of banks reported doing so for credit-card loans. Less abundant credit—coupled with higher-priced food and fuel—helped drive down consumer spending growth to 0.2 percent in July, from 0.6 percent in June. David Ressler, chief economist at Nomura Securities, expects consumer spending growth to turn negative in the third quarter for the first time in 17 years.

Meanwhile, higher mortgage rates—now roughly a full percentage point above where they would be if credit markets were functioning normally—make home buying more expensive even as prices drop. That could force house prices even lower and prolong the worst housing slump since the Great Depression. And although business spending has held up so far, Ressler expects tighter credit and lower profits to weaken it in the second half of this year. What's more, these developments come as export growth—the one bright spot in the U.S. economy—appears likely to fade as overseas markets cool off.