"Apart from the aftermath of 9/11, this is the largest percentage decline (of commercial paper) since September 1982. Moreover, borrowers who continue to have access to this market have found that they can roll the paper over only for much shorter maturities," said the Goldman Sachs Economic Research Team, in a note Friday to investors. "This has almost certainly caught the eye of Fed officials, and is a problem that ultimately cannot be allowed to persist for long.
The current Wall Street woes resemble the unraveling savings and loan crisis that helped trigger a recession in 1990-91. Back then, weakly regulated lenders had a huge bad-loan portfolio largely hidden from public view. These bad loans eventually hurt the broader economy and led to a government bailout costing more than $175 billion.
Today's financial crisis is rooted in a flood of unsound sub-prime loans to weak borrowers. The loans were bundled together and sold to investors as mortgage bonds. It's not clear the degree to which investment banks and mortgage lenders hold bad loans, and that is at the heart of fears on Wall Street - that like the savings and loan crisis, many lenders could be on shakier ground than they are admitting.
"The question is, is that going to happen again? I don't think so, but I'd love to be more certain," said Irwin M. Stelzer, director of economic studies at the Hudson Institute, a conservative think tank.
Fed moves to provide more cash and credit in the banking system aim to prevent a cash-flow crisis for lenders, especially mortgage lenders. But some prominent economists, including former Fed governor Lyle Gramley, believe that the next move belongs to the Bush administration, not the Fed.
Gramley argues that the administration should lift caps on government-sponsored home-finance enterprises like Freddie Mac and Fannie Mae so they can purchase existing home loans and bundle them together with safer mortgage-backed securities. Lifting the caps on Fannie Mae and Freddie Mac would give a home to the risky assets that are unnerving Wall Street and threatening the broader economy.
"If those caps were lifted temporarily, then Fannie and Freddie could perform their historic role of providing liquidity to the market, which desperately needs it," Gramley said.
President Bush told economic writers last week that he opposes this sort of bailout for lenders, but failing to lift the caps could turn a housing downturn into a full-blown recession by next year - right in the middle of a presidential election.
"I think the political implications of that are going to dawn on somebody pretty soon," said Gramley.
In trying to prevent the current volatility from snowballing into a recession, the Fed has been walking a fine line. It doesn't want to bail out banks and borrowers that made unsound business decisions, nor does it want to ignore inflation, which is on the high side of its tolerance level.
But the Fed also doesn't want to heed those priorities at the expense of the broader economy, nor risk a complete collapse of the troubled housing market. Credit markets have virtually seized up for home lending, and if left unresolved that could lead to deep drops in home prices, which almost certainly would lead to recession.