A cloud over the economy: the mortgage meltdown is deepening, and prolonging the housing recession. A weak housing sector has ripple effects for the rest of the U.S. economy. Financial markets remain vulnerable to renewed turmoil from hidden exposures to subprime mortgages and related derivatives

Mortgage Banking, Nov, 2007 by Robert Stowe England

Shiller notes that the last time foreclosures rose dramatically, during the 1930s, "it had a powerful impact on confidence and led to a powerful regulatory response" in Washington. "I suspect we will see that. Congress is not going to sit idly by with houses in foreclosure. They won't sit idly by while millions of people lose their homes," he says.

People are edgy--not just about the economy, but about systemic risks, particularly to financial institutions, Shiller says. He suggests that one thing Congress should do to address public confidence is to raise the ceiling on Federal Deposit Insurance Corporation (FDIC) deposit insurance.

"It has been fixed at $100,000 since 1980," he says. "If you take that as a ratio to income, it has lost 85 percent of its value, because incomes have grown in real and inflationary terms." A $100,000 account is not such a big account anymore, he adds.

"The risks are the same as those that faced Northern Rock. That could happen here," claims Shiller.

A run on Northern Rock plc, Newcastle upon Tyne, England, began on Sept. 13 and depleted the bank of $4 billion in deposits in a matter of days, according to a Sept. 16 BBC report. Northern Rock's chief executive officer, Adam Apple-garth, declined to give a figure--or confirm or deny the BBC report, according to USA Today. Customers were lined up around the block to take out their deposits at branches all across Britain. The run was halted Sept. 19 only after The Bank of England took the extraordinary step of guaranteeing all the deposits in the bank as of that day. Northern Rock is one of Britain's largest mortgage lenders.

Shiller notes that the Federal Housing Administration (FHA) was created during the last big housing crisis in 1934, and it served as the subprime lender in this country. "It did not do lending. It made possible subprime lending. It has lost its share of that market," he says. He thinks that the current housing bust will lead Congress to expand the roles of both the FHA and the Department of Veterans Affairs (VA), which guarantees home loans made to veterans.

More rate cuts on the way?

Some economists and Wall Street observers believe the Fed will need to lower the Fed Funds Rate further to prevent the economy from falling into recession. The sudden reversal in tone at the Fed on Aug. 9, when it announced the first 50-basis-point cut in the discount rate, signaled a change of heart by Chairman Bernanke and the Federal Open Market Committee (FOMC), which had only a few days earlier signaled they were still predominantly concerned about inflation.

"Bernanke's calculations were completely wrong when he said earlier in the year that damage would be confined to the subprime sector," says Investor Security Trust Co.'s Jones. After Bernanke's reassurances in late spring that the subprime fallout was contained, the subprime contagion knocked out two hedge funds at New York-based Bear Stearns Co. Inc. It then spread around the globe hitting financial institutions with any connection to U.S. subprime and others, eventually knocking down two funds at Paris-based BNP Paribas on Aug. 9. Problems at two funds at BNP Paribas, in turn, helped prompt a big global sell-off in stocks.