Credit Crisis Strains Government's Options

A year into a credit crisis that started with troubled mortgages to sketchy borrowers, the financial system is reeling once again, casting a pall over a widening array of financial institutions just days after history-making efforts by policy makers to contain the problem.

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Federal officials and market players are struggling with the same issues: Why haven't the steps taken so far calmed the system? What can policy makers do next? Should the U.S. government let a big institution fail rather than stage another potentially costly bailout?

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Among reasons for optimism: Falling oil prices could eventually provide relief to consumers and a stronger dollar has taken pressure off inflation. U.S. officials hope that the rescue of Fannie and Freddie will help lower mortgage rates, and financial firms have already raised billions of dollars of fresh capital.

But other measures of financial conditions are as bad as they were back in March, when the Fed and Treasury arranged the abrupt takeover of Bear Stearns by J.P. Morgan Chase & Co. For instance, junk bonds now yield 8.55 percentage points more than safe Treasury bonds, a spread that is about as wide as it was in March. These spreads widen as investors become more fearful about risk.

Banks are also finding it more costly to fund themselves. Wells Fargo & Co. of San Francisco, which has weathered the crisis better than most peers, was forced this month to promise higher-than-expected yields on debt securities it issued in order to lure nervous investors. Last month, Citigroup Inc., American International Group Inc. and American Express Co. all faced weak demand for bond issuances that pushed up the yields they had to pay.

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Second, households and financial institutions aren't finished with a painful process known as deleveraging, in which they reduce their reliance on debt.

These two processes -- deleveraging and soft consumer spending -- can feed on each other, something economists call an adverse feedback loop. Deleveraging puts downward pressure on home prices. That, in turn, forces financial institutions to deleverage more. In the same way, falling home prices squeeze households, which forces them to cut back on spending and puts off a housing recovery, further weighing on home prices.

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U.S. officials are not powerless to confront the crisis. But they are far more constrained than they were a year ago, after taking a series of steps to bolster financial markets, including slashing interest rates.

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Doing more could lead to other problems. Fed officials are wary of pushing short-term interest rates lower. At 2%, the federal-funds rate is 3.25 percentage points lower than it was a year ago, and looks likely to stay on hold because the Fed worries that more rate cuts would worsen inflation. What's more, other interest rates, such as mortgage rates, remain elevated as previous rate cuts have been counteracted by the force of the credit crunch. It's not clear that further cuts would have much effect in bringing down other rates.

Officials are also acutely aware of the problem of "moral hazard." Bailing out too many firms, the reasoning goes, would encourage more risk taking in the future. That makes officials reluctant to be seen as rescuing another institution. The Fed made a $29 billion loan to help J.P. Morgan take over Bear Stearns. It's not clear that it would be willing to do that for another firm.