Downturn gains steam as inflation roars ahead

By Martin Crutsinger and Jeannine Aversa, AP Economics Writers

Inflation rises at fastest pace since early 1980s as Fed chair warns of more trouble

WASHINGTON (AP) -- The U.S. economic downturn gained steam Tuesday, with a report of the highest inflation since the early 1980s, more bad news for banks and automakers and a suggestion by the Federal Reserve chief that worse days are ahead.

President Bush sought to bolster confidence by declaring that the financial system was "basically sound," but he conceded: "It's been a difficult time for many American families."

The Labor Department said wholesale inflation, driven by skyrocketing gas and food costs, rose by 9.2 percent for the 12 months ending in June -- the fastest pace since the summer of 1981, during another energy crunch.

At the same time, consumers hit the brakes hard despite a massive infusion of government stimulus checks. Retail sales turned in their poorest showing in four months.

Federal Reserve Chairman Ben Bernanke delivered a somber midyear outlook to Congress, saying the U.S. faces "numerous difficulties" despite the Fed's interest rate-cutting campaign, which began last September in hopes of preventing a recession.

Bernanke said the Fed expected the economy to grow for the rest of this year "appreciably below its trend rate." He cautioned inflation was likely to move "temporarily higher" in the near future.

That puts the Fed in a bind: Rising inflation hamstrings the Fed from cutting interest rates to jump-start the economy. The Fed had already signaled last month the rate cuts were probably at an end.

Outside Washington, there was plenty more bad news. On Wall Street, the Dow Jones industrials closed below 11,000 for the first time in two years, and shares of troubled mortgage giants Fannie Mae and Freddie Mac tumbled again. Fannie shed 27.3 percent and Freddie lost 26 percent.

In Los Angeles, police had to order people lined up outside an IndyMac Bank branch to remain calm or face arrest as they tried to pull out their money on the second day of the failed institution's federal takeover.

An analyst downgraded Wachovia Corp. and said the outlook for its shareholders is "bleak." Its already-battered stock sank about 7.7 percent further, to $9.08. U.S. Bancorp posted an 18 percent drop in second-quarter profit and tripled its provision for credit losses.

General Motors said Tuesday it plans to lay off salaried workers, cut truck production and suspend its stock dividend, all in an effort to raise $15 billion to help turn around its North American operations.

The dollar hit a new low against the euro. And even good news came with a dark side: Oil prices fell by more than $6 per barrel -- the biggest single-day drop in 17 years -- as traders fretted that the slowing U.S. economy would dampen demand for crude.

"The country is in a bad spot right now, squeezed by high and accelerating inflation and a very weak economy and struggling to overcome a very severe financial shock," said Mark Zandi, chief economist at Moody's Economy.com.

Wholesale prices for goods before they reach consumers rose by 1.8 percent in June from a year earlier and at 9.2 percent for the 12 months ending in June. Core inflation, which excludes food and energy, was better behaved, rising by just 0.2 percent in June, slightly lower than expected.

Food costs were up 1.5 percent, the biggest increase since January, led by steep gains in the cost of vegetables and eggs. Even pet food jumped by 6 percent, the largest monthly increase on record.

Wholesale energy prices shot up 6 percent. The price of unleaded regular gas surged 9 percent in June on top of a similar increase in May. Home heating oil, natural gas and liquefied petroleum gas also took big jumps.

Retail sales were up just 0.1 percent in June, the worst showing since February. That figure reflected a huge drop in auto sales and would have been even worse had it not been for a big jump in gas sales -- reflecting higher prices, not demand.

Analysts were particularly alarmed by the retail sales report because consumer spending accounts for two thirds of total economic growth. The weak sales came as the government was pumping out $28 billion in economic stimulus checks, bringing the total payments to $78 billion by the end of June.

Those same analysts worried what will happen after the government finishes mailing out the bulk of the checks this month.

"Clearly the economy is on the ropes with weak employment market conditions, declining home and equity prices and surging gasoline prices inducing the consumer to pull back," said Brian Bethune, chief U.S. financial economist at Global Insight.

Despite tough talk on inflation from Bernanke, many analysts predicted that the Fed will keep interest rates unchanged for the rest of the year to give the financial system some breathing room to deal with a tidal wave of mortgage defaults. Those have already resulted in an estimated $400 billion in losses at financial institutions.

Treasury Secretary Henry Paulson, appearing with Bernanke before the Senate Banking Committee, came under a barrage of tough questions about an emergency plan to bolster Fannie and Freddie, which between them hold or guarantee more than $5 trillion in mortgage debt -- nearly half of the nation's mortgage debt.

The plan would have Congress authorize billions of dollars of government help should the two giant institutions come under increased pressure because of the surge in mortgage loan losses. As a last resort, the government could also invest directly in Fannie and Freddie.

But both Democrats and Republicans on the committee questioned why the administration was seeking what critics term a bailout for two big corporations, with taxpayers left holding the bag in the event of severe losses.

Paulson insisted taxpayers were being protected and said the offer of government help should be enough to calm jittery markets.

In a Tough Economy, Timing Is Everything

by Suze Orman

Sharply falling stock market and home values have created an extremely treacherous period. It's in just this sort of tough economic environment that your future financial security is won or lost.

How you handle your money in these tough times is going to play a huge role in whether you reach your long-term financial goals. Unfortunately, I'm seeing far too many people focused on making moves that might bring some short-term relief without fully recognizing the long-term damage they're doing to their bottom line.

It's Too Early to Hibernate

The stock market has officially fallen into bear market territory, with the Dow Jones Industrial Average sinking 20 percent below its October 2007 high. Watching your portfolio take a big hit probably has you seriously considering making a beeline for the nearest exit, but please slow down and think this through.

Emotionally, it makes perfect sense to want to bail on the stock market. But emotions are what keep individuals from making smart investing decisions. Look no further than the ever-growing cadre of behavioral economists who make a living by studying how we cheat ourselves with misguided money moves.

Heading into investing hibernation right now is one of those moves. I'm not predicting that the market has absolutely bottomed, but to bail out now puts you at odds with the immutable law of successful investing: Buy low, sell high.

Many Unhappy Returns

Selling now also plays right into the timing trap that's thwarted so many individual investors. We need to look no further than the data provided by Dalbar Inc., which takes a look at how fund investors have historically fared when compared to the performance of the S&P 500 stock index.

It's not a pretty picture. For the 20 years from 1987 through 2007, the S&P 500 gained an annualized 11.8 percent. The returns for investors in mutual funds over that period were just 4.4 percent.

What gives? Really bad market timing. In that period, individual investors had a knack for getting in and out of stocks at just the wrong time; if they'd just sat tight they would've pocketed more than twice -- actually close to three times -- the gains they actually earned.

History Rewards the Long-Term Investor

That brings us back to today. If you're a long-term investor -- that is, if you expect to leave your money invested for at least 10 years -- the evidence is pretty clear that sticking it out as a buy-and-hold investor is going to be your best (non-) move. That's especially true if you're investing via a 401(k).

Your money buys you more shares today -- given lower stock values -- than it would if you bought at higher valuations. Invest $250 per paycheck in your 401(k) in funds that have a share price of $25 and you get 10 shares. Invest when those shares fall to $20 and your $250 buys you 12.5 shares. Fast-forward 10 years and the shares that have bobbed both up and down but are now worth, say, $30. If you had 10 shares your account is worth $300. With 12.5 shares you have $375.

Of course, this assumes that over long periods of time the market gains more than it loses. That might be hard to imagine right now, but we all know that over time -- decades of history -- the stock market has a long-term bias to trend up, not down. Folding now makes no sense if you're investing for a long-term goal.

What are your alternatives anyway? Don't tell me the 3 percent or so you can get at the bank or the 4 percent in a Treasury bond is a good, safe investment. There's nothing safe about having money you need to grow earn a guaranteed rate of return that's well below the rate of inflation.

Homing in on Reality

The slide in home values is creating another "timing" issue for many individuals. In addition to the few million homeowners who are already in or close to foreclosure, some economists are now projecting that another 2 to 3 million could find themselves in serious trouble over the coming year or so if home values continue to falter and a weak economy causes unemployment rate to rise.

The typical response to being in mortgage stress is to pull out all the financial stops to stay in the home. That includes raiding retirement savings, running up huge credit card debt, and borrowing from any and every family member or friend to come up with the cash to cover their rising mortgage costs. Again, emotionally this makes perfect sense -- the desire to stay in homes we ostensibly "own" is profound. But if the only way you can afford your home is to ruin the rest of your financial life, what have you really achieved?

It's very sad to say, but I think many homeowners need to seriously consider "folding" if the reality is that they have no way of being able to afford the higher mortgage payments in the long term. In fact, the latest round of housing aid being discussed by Congress would limit federal assistance to homeowners who could afford the cost of a 30-year mortgage. That's Washington's line in the sand: Help will be limited only to those homeowners who are able to make a go of it at a real market rate.

Know When to Fold 'Em

It should be your litmus test, too. Run the numbers using this Yahoo! Finance calculator: Plug in 6 percent for the interest rate and 360 for the term of the loan (that's 360 months, which is the full term for a traditional 30-year mortgage: 30 years x 12 months=360.) Then take a look at that monthly mortgage amount. Can you afford it today, without running your savings dry and your credit cards into the stratosphere?

If the answer is no, then you need to look at the big picture. It makes little sense to throw good money (what savings you have) at a bad situation you know you can't afford long-term. As painful as it is to consider selling, or going through foreclosure now, it can be the smarter move than trying to "hold on" for another six months, or year, or two years, until you have no more money to raid.

There are no miracle bailouts on the way. If Congress does step up to the plate, it looks like any assistance at this point is going to be very limited. Nor should you cross your fingers that housing values seriously bounce back in the near term and give you enough equity to easily refinance. And with the economy struggling, the chance of getting a big raise doesn't seem too likely. The bottom line: Keep your retirement savings intact and put away that credit card. It's time to consider folding -- hopefully through a sale and not foreclosure -- so you can get your financial house back in order.

Analysts Say More Banks Will Fail

By LOUISE STORY

As home prices continue to decline and loan defaults mount, federal regulators are bracing for dozens of American banks to fail over the next year.

But after a large mortgage lender in California collapsed late Friday, Wall Street analysts began posing two crucial questions: Just how many banks might falter? And, more urgently, which one could be next?

The nation’s banks are in far less danger than they were in the late 1980s and early 1990s, when more than 1,000 federally insured institutions went under during the savings-and-loan crisis. The debacle, the greatest collapse of American financial institutions since the Depression, prompted a government bailout that cost taxpayers about $125 billion.

But the troubles are growing so rapidly at some small and midsize banks that as many as 150 out of the 7,500 banks nationwide could fail over the next 12 to 18 months, analysts say. Other lenders are likely to shut branches or seek mergers.

“Everybody is drawing up lists, trying to figure out who the next bank is, No. 1, and No. 2, how many of them are there,” said Richard X. Bove, the banking analyst with Ladenburg Thalmann, who released a list of troubled banks over the weekend. “And No. 3, from the standpoint of Washington, how badly is it going to affect the economy?”

Many investors are on edge after federal regulators seized the California lender, IndyMac Bank, one of the nation’s largest savings and loans, last week. With $32 billion in assets, IndyMac, a spinoff of the Countrywide Financial Corporation, was the biggest American lender to fail in more than two decades.

Now, as the Bush administration grapples with the crisis at the nation’s two largest mortgage finance companies, Fannie Mae and Freddie Mac, a rush of earnings reports in the coming days and weeks from some of the nation’s largest financial companies are likely to provide more gloomy reminders about the sorry state of the industry.

The future of Fannie Mae and Freddie Mac is vital to the banks, savings and loans and credit unions, which own $1.3 trillion of securities issued or guaranteed by the two mortgage companies. If the mortgage giants ever defaulted on those obligations, banks might be forced to raise billions of dollars in additional capital.

The large institutions set to report results this week, including Citigroup and Merrill Lynch, are in no danger of failing, but some are expected to report more multibillion-dollar write-offs.

But time may be running out for some small and midsize lenders. They vary in size and location, but their common woe is the collapsed real estate market and souring mortgage loans. Most of these banks are far smaller than the industry giants that have drawn so much scrutiny from regulators and investors.

Still, only six lenders have failed so far this year, including IndyMac. In 1994, the Federal Deposit Insurance Corporation listed 575 banks that it considered to be troubled. As of this spring, the agency was worried about just 90 banks. That number may go up in August, when the government releases an updated list.

“Failed banks are a lagging indicator, not a leading indicator,” said William Isaac, who was chairman of the F.D.I.C. in the early 1980s and is now the chairman of the Secura Group, a finance consulting firm in Virginia. “So you will see more troubled, more failed banks this year.”

And yet IndyMac, one of the nation’s largest mortgage lenders, was not on the government’s troubled bank list this spring — an indication that other troubled banks may be below the radar.

The F.D.I.C. has $53 billion set aside to reimburse consumers for deposits lost at failed banks. IndyMac will eat up $4 billion to $8 billion of that fund, the agency estimates, and that could force it to raise more money from the banks that it insures.

The agency does not disclose which banks it thinks are troubled. But analysts are circulating their own lists, and short sellers — investors who bet against stocks — are piling on. In recent weeks, the share prices of some regional banks, like the BankUnited Financial Corporation, in Florida, and the Downey Financial Corporation, in California, have stumbled hard amid concern about their financial health. A BankUnited spokeswoman said the lender had largely avoided risky subprime loans.

In his “Who Is Next?” report over the weekend, Mr. Bove listed the fraction of loans at banks that are nonperforming, meaning, for example, that the assets have been foreclosed on or that payments are 90 days past due. He came up with what he called a danger zone, which was a percentage above 5 percent. Seven banks fell in this category.

An important issue for the regional and community banks will be whether they have managed to sell their riskiest loans to Wall Street firms.

And the government may have fewer failures than in the past because private investment funds might buy some troubled lenders. Regulators are considering rule changes that would allow private equity firms to buy larger shares of banks, and several prominent investors, like Wilbur Ross, have raised funds to leap in.