Source: Bloomberg

Credit market turmoil has driven the U.S. into a recession and may topple some of the nation's biggest banks, said Kenneth Rogoff, former chief economist at the International Monetary Fund.

``The worst is yet to come in the U.S.,'' Rogoff, a Harvard University professor of economics, said in an interview in Singapore today. ``The financial sector needs to shrink; I don't think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job.''

The U.S. housing slump has triggered about $500 billion in credit market losses for banks globally and led to the collapse and sale of Bear Stearns Cos., the fifth-largest U.S. securities firm. Bonds of regional banks such as National City Corp. and Keycorp are under pressure on expectations of more fallout. Rogoff, 55, said the government should nationalize Fannie Mae and Freddie Mac, the nation's biggest mortgage-finance firms.

Freddie Mac and Fannie Mae ``should have been closed down 10 years ago,'' he said. ``They need to be nationalized, the equity holders should lose all their money. Probably we need to guarantee the bonds, simply because the U.S. has led everyone into believing they would guarantee the bonds.''

Last month, President George W. Bush signed into law a housing bill that provides Treasury Secretary Henry Paulson the power to make equity purchases in Fannie Mae and Freddie Mac. Paulson asked for the authority July 13 after the shares of the firms, which own or guarantee almost half of the $12 trillion of U.S. mortgages, slid to the lowest level in more than 17 years.

Shares Slump

The mortgage lenders have been battered by record delinquencies and rising losses. Fannie Mae fell 14 cents to $6.01 at 4 p.m. in New York Stock Exchange composite trading, its lowest level since May 1989 amid concern the government- chartered companies will fail to raise the capital they need to offset losses. Freddie Mac declined 5 percent to the lowest since January 1991.

Banks repossessed almost three times as many U.S. homes in July as a year earlier and the number of properties at risk of foreclosure jumped 55 percent, according to RealtyTrac Inc., an Irvine, California-based seller of foreclosure data. U.S. builders broke ground on the fewest houses in 17 years last month, according to a Bloomberg News survey.

Rogoff told a conference in Singapore today that the credit crisis is likely to worsen and a large bank may fail, Reuters reported earlier. He was the IMF's chief economist from August 2001 to September 2003.

``Like any shrinking industries, we are going to see the exit of some major players,'' Rogoff told Bloomberg, declining to name the banks he expects to fail. ``We're really going to see a consolidation even among the major investment banks.''

IndyMac Bancorp

IndyMac Bancorp Inc., once the second-largest U.S. independent mortgage lender, filed for bankruptcy protection Aug. 1, three weeks after it was taken over by the Federal Deposit Insurance Corp. amid a run by depositors that left it strapped for cash. Bear Stearns collapsed in March and sold itself to JPMorgan Chase & Co. for $10 a share.

``The only way to put discipline into the system is to allow some companies to go bust,'' Rogoff said. ``You can't just have an industry where they make giant profits or they get bailed out.''

Federal Reserve Chairman Ben S. Bernanke, seeking to allay renewed concerns over the health of the nation's financial system, said on July 8 that the central bank may extend its emergency-loan program for investment banks into next year.

Regulatory Gap

His comments followed calls by Paulson for regulatory changes that would allow financial firms to fail without threatening market stability.

Paulson has identified a legal gap that leaves unspecified how to deal with failures of companies that don't take deposits, such as investment banks. He proposed tightening supervisors' oversight of lenders and dealers while at the same time discourage companies from depending on a government rescue if their bets go wrong.

``We need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm,'' Paulson said in a speech in London on July 2.

In the case of commercial banks, the use of taxpayer funds in an emergency requires the approval of two-thirds majorities of the FDIC and Federal Reserve boards, and of the Treasury secretary in consultation with the president.

U.S. Recession

The world's largest economy is already in a recession, and the housing market will continue to deteriorate, Rogoff said. The U.S. slowdown will last into the second half of next year, he said, predicting a faster recovery in Europe and Asia.

The Federal Reserve, which has left its key interest rate at 2 percent after the most aggressive series of rate reductions in two decades, risks raising inflationary pressures, he said.

``Rates are too low,'' Rogoff said. ``They must realize we're going to get inflation if things stay where they are. They need to raise rates but I don't think they are going to because they're way too nervous.''

To contact the reporter on this story: Shamim Adam in Singapore at sadam2@bloomberg.net.