Bernanke Says Recession Possible

Updated from 12:27 p.m. EDT

Federal Reserve Chairman Ben Bernanke on Wednesday acknowledged the possibility of recession, as lawmakers grilled him on the government's bailout of Bear Stearns (BSC Quote) and the merits of federal aid for struggling homeowners.

In his latest economic forecast, Bernanke predicted that real GDP "will not grow much, if at all, over the first half of 2008 and could even contract slightly." He later crossed a rhetorical line for government officials by acknowledging that "recession is possible" for the economy this year in response to a question. A recession is widely defined as two straight quarters of contraction in GDP growth.

Bernanke appeared to be backing off his previous expectation of "moderate growth" expressed in the Fed's March 18 policy statement.

Bernanke did reiterate that the Fed expects the economy to strengthen in the second half of the year, due to low interest rates combined with the legislated tax rebates that consumers will receive later this year. He also forecasted economic growth in 2009, but he qualified the central bank's outlook by noting that "risks remain to the downside," due to persistent turmoil in financial markets and heightened uncertainty about the future.

"Although our recent actions appear to have helped stabilize the situation somewhat, financial markets remain under considerable stress," said Bernanke, in his prepared remarks to the Joint Economic Committee in Congress. "Pressures in short-term bank funding markets, which had abated somewhat beginning late last year, have increased once again. Many lenders have been reluctant to provide credit to counterparties, especially leveraged investors, and have increased the amount of collateral they require to back short-term security financing agreements.

"To meet those demands, investors have reduced their leverage and liquidated holdings of securities, putting further downward pressure on security prices," Bernanke added.

Bear Stearns notified the Fed on March 13 that its liquidity position was eroding and the investment bank was on the verge of bankruptcy. In response, the Fed backstopped nearly $30 billion of Bear's riskiest mortgage-related securities to orchestrate a swift acquisition of the bank by JPMorgan Chase(JPM Quote) for a stunning $2 a share. JPMorgan later renegotiated the price up to $10 a share.

"Normally, the market sorts out which companies survive and which fail, and that is as it should be," said Bernanke. "However, the issues raised here extended well beyond the fate of one company."

He noted that Bear Stearns participates extensively in critical financial markets and the fallout from its bankruptcy could have been difficult to contain.

"With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence," said Bernanke. "The company's failure could also have cast doubt on the financial positions of some of Bear Stearns' thousands of counterparties and perhaps of companies with similar businesses."

Based on Bernanke's willingness to extend government aid to Bear Stearns to prevent further catastrophe, the Democratic-controlled Congress pressed the Fed chairman on whether a fiscal bailout for homeowners facing foreclosure is appropriate, given the damage that falling home prices are inflicting on the broader economy.