Shock bailout vote heightens recession specter

WASHINGTON (Reuters) - The U.S. economy was in dangerous waters before a shock House of Representatives vote on Monday to reject a bailout for troubled financial firms and it now even closer to being on the rocks.

Credit markets have seized up, banks are failing in Europe or facing arranged marriages in the United States while frightened consumers clutch their wallets closely -- all warning signs that economic activity was near grinding to a halt.

Analysts said lawmakers' rejection of a taxpayer-financed bailout -- never popular but widely thought necessary -- heightens the risk that a deepening U.S. banking malaise will spread more rapidly abroad and worsen a developing slowdown.

"Today's vote not to pass the $700 billion package to aid the liquidity crisis has raised the probability of a global recession as capital flows seize in the entire system," said Chris Jarvis, senior analyst with Caprock Risk Management in New York, warning it may soon be felt by ordinary consumers.

In recent days, banks have been increasingly hoarding cash and may now be so reluctant to lend that longstanding relationships with businesses risk being interrupted to the extent that some could have difficulty meeting payrolls.

Gary Thayer, chief economist at Wachovia Securities in St. Louis, warned "it won't be long," and possibly only days, before the impact is felt on Americans' day-to-day affairs.

PINCH COMING SOON

"We're already seeing a weak economy and if we don't see the credit markets improve within the next week or two, we'll start to see some businesses having difficulty in getting credit," he said. "This could lead to increased layoffs within the next month."

Consumer confidence already was shaky and a report on Monday showed spending in August was flat. Markets have shared that nervousness and stock prices plunged after the House of Representatives voted down the plan. The Dow Jones industrial average shed nearly 7 percent, or 778 points -- its largest one-day point drop ever.

The bailout proposal would have given the Treasury authority to buy illiquid and unwanted assets, like non-paying mortgages from banks, credit unions and other firms, in the hopes of purging the financial system of bad debts and persuading banks to keep credit flowing.

Precisely why the vote failed was unclear, since Democrats and Republicans huddled throughout the weekend and seemed to have reached a compromise on Sunday. Republicans portrayed it as a bailout for Wall Street, unpopular because they considered financial firms largely at fault for the problem.

SET DIFFERENCES ASIDE

Analysts said whatever their differences, lawmakers should accept the urgency for some action, if only to lessen the severity of an economic downturn that already appears to be in the cards.

"I believe we are in a recession and (it) is going to deepen in the final quarter of the year," said Bernard Baumohl, executive director of the Economic Outlook Group in Princeton Junction, New Jersey. "The holiday shopping season could easily be the worst in two or three decades and the recession could last through the middle of 2009."

After a meeting with President George W. Bush, other top White House advisers and Federal Reserve Chairman Ben Bernanke, the administration figure at the center of the storm, Treasury Secretary Henry Paulson, said the banking system was handling the strain so far.

Still, he left no doubt he was worried.

"Our banking system has been holding up very well, considering all the pressures," Paulson told reporters on the White House driveway. He acknowledged, however, that the Treasury and the Federal Reserve were pushing the limits in keeping the system liquid.

"We have significant tools in our tool kit but they're not sufficient," the former Wall Street CEO said. "We need to put something back together that works. We need it as soon as possible."

(Editing by Gary Crosse)