As faith in bank bailouts dims, losses set to deepen

By Pedro Nicolaci da Costa - Analysis

NEW YORK (Reuters) - The nightmare scenario for U.S. economic authorities is here: confidence in their ability to rescue the country from a housing-led financial panic is now at its lowest level since the crisis began.

This means losses for investors, already totaling nearly half a trillion dollars, could mount even further over the next few months, with implications for business investment and the overall health of the economy.

"You see a massive potential for financial meltdown on a global scale," said T.J. Marta, fixed-income strategist at RBC Capital Markets.

Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson, testified before Congress this week on the country's precarious financial state. They were met with unusually fierce questions from lawmakers on the feasibility of a plan to provide extra funding for mortgage finance giants Fannie Mae (FNM.N) and Freddie Mac (FRE.N).

"I will use every power in my arsenal to stop this," said Jim Bunning, Republican Senator from Kentucky, berating the Treasury initiative in no uncertain terms.

The government's vow to back the institutions largely failed to restore faith in a near-term recovery for battered financial markets. After a momentary jolt higher on Monday, U.S. stocks ended lower. The Dow Jones industrial average on Tuesday slipped below 11,000 for the first time in two years.

U.S. shares did recover on Wednesday, but this was largely due to a rapid retreat in oil prices than any renewed confidence in credit markets or growth prospects.

"People's horizons are moving out to 2009 and they are still not seeing any end in sight and with credit losses increasing that's really not good news," said Steve Goldman, market strategist at Weeden & Co., in Greenwich, Conn.

"The backstop with Freddie Mac and Fannie Mae doesn't deal with heart of the problem: foreclosures, supply."

BAILOUT FATIGUE

Fannie Mae and Freddie Mac together own or guarantee about $5 trillion in mortgages, about half of the entire U.S. mortgage market. The bond market's reaction to the Treasury's vow to support the government-sponsored entities was telling. U.S. Treasury bond prices rallied sharply on Tuesday despite a 9.2 percent year-on-year jump in producer level inflation, the biggest in almost 30 years.

This counterintuitive reaction for government debt, whose fixed returns make them highly-sensitive to inflation, indicates just how frantic investors have become. They would rather hold paper whose value might be eroded over time than face the prospect of immediate losses in riskier assets like equity shares or asset-backed bonds.

"No one knows where it is going to end for stocks," said Robert Macintosh, chief economist at Eaton Vance Corp., in Boston. "Talk about a negative tone, no matter what anybody says or does it seems to get worse."

Especially hard hit, U.S. bank shares fell this week to their lowest level since 1996 on fears of seemingly endless losses.

The renewed risk aversion was also salient in very short-term government bills. The TED spread, the gap between 3-month bills and interbank rates of similar maturity, has widened to its worst levels since April.