THE rot in the US financial system is spreading and becoming more menacing. Federal Reserve chairman Ben Bernanke, who is determined that it not become a self-fulfilling spiral, on Thursday signalled that the Federal Reserve stood ready to supply more aggressive rate cuts if needed.

The biggest US home lender, Countrywide, has teetered on the brink of bankruptcy, facing trouble raising funds as the level of defaults and delinquency in its loan book rises.

In what may turn out to be its last annual report, Countrywide sets out the goal that has brought it to the edge of doom.

"We are determined to play a critical role in ensuring that the dream of home ownership is attainable to everyone with the ability and willingness to meet their mortgage obligations."

It aimed to lend $US1 trillion ($1.123 trillion) to Afro-American, Hispanic and other groups who had been excluded from home ownership, and proudly boasted reaching $US668 billion by the end of 2006.

As of the end of 2007, the business was the victim of a shotgun takeover by the Bank of America, with the Fed's Ben Bernanke holding the gun. There is rising concern about the financial health of the two government-backed institutions Fannie Mae and Freddie Mac, which underwrite the mortgage lending of the banks.

Although they do not take on sub-prime loans, they have a wafer-thin capital base that is increasingly exposed, as the problems in the US housing market spread beyond the foreclosures on sub-prime borrowers.

Between them, they have $US4000 billion in mortgages (about five times the size of the Australian GDP) supported by about $US80 billion in capital.

About a quarter of their loans are to higher-risk clients, such as low-doc loans and high loan-to-value ratio loans.

With a government guarantee, they cannot fail. However, they are tied to other markets through financial derivatives, so any problems would have ructions elsewhere. Their share prices have dropped by more than half since October.

There is no confidence that the write-offs are over at the big city banks. A fresh round is likely to be announced over coming weeks as banks start to report their 2007 results.

Several of the banks, including Citigroup, UBS Merrill Lynch and Morgan Stanley, have been supported by large capital injections from sovereign wealth funds of Asian and Middle East origin.

However, as ANZ international economist Amy Auster notes, they are still being forced to take back onto their balance sheets all sorts of exposures that they never wanted there in the first place. Structured credit products such as CDOS (collateralised debt obligations) were designed to bundle risks in a form that could be kept off balance sheet. Bringing them back is constraining the banks' ability to lend. To free up the balance sheet, these assets need to be sold, but there are no buyers.

"CDOs and similar asset-backed structures have a huge cloud over them, with a lack of confidence in the methodology of the rating agencies," Auster says.

Defaults have been at historically low levels, but as they rise, there are concerns as to what will become of the credit default swap market, which has emerged in recent years to insure lenders against the possibility that borrowers may fail.

Chief investment officer with the bond manager Pimco, Bill Gross, believes bond defaults may return to a historical level of around 1.25 per cent this year, which he says could result in losses of $US250 billion or more to the investors in default swaps.

Premiums on credit default swaps have been rising, adding fresh pressure to funding costs. At Bear Stearns, for example, credit default swaps have risen from about 20 basis points in the middle of last year to 230 basis points. At Citigroup, they have gone from about 7 basis points to 90 basis points. The concern for default has extended to Australia, where spreads have risen from about 35 to 85 basis points in the last two months.

The fallout from the financial economy into the general economy is becoming more intense. Foreclosures are forcing housing sales into a falling market. There is no longer demand for housing from people without good credit histories. The tightening of finance is also starting to spill into the commercial property industry, where developers are finding it harder to obtain or roll over debt.

The fall in housing prices and now the fall in shares are eroding household wealth. The American consumer, who keeps the great flywheel of the US economy spinning, is pulling back.

Retailers had poor sales across the Christmas period, with major chains reporting sales 2-5 per cent below last year's. Motor vehicle sales were down by 2.9 per cent.

In a bleak assessment delivered last Thursday, Bernanke said the downturn in the housing industry was becoming more pervasive and weighing on consumer sentiment.

"The baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced," he said.

Unemployment is beginning to rise, throwing a further shadow over the outlook for consumer spending.

Bernanke said the Federal Reserve stood ready to "take substantive additional action as needed to support growth and to provide adequate insurance against downside risks".

Within financial markets, this was interpreted as a signal that the official rate will be cut from 4.25 to 3.75 per cent at the next Federal Open Market Committee meeting on January 30.

For a long time it was hard to square the dismal state of the housing market with the health of the economy, where the figures were great for profits, business investment, manufacturing activity and exports.

It was tempting to conclude that financial market woes would be largely contained and that US growth, although lower, would remain comfortably in positive territory. This has been the benchmark assumption of the IMF, the OECD and the Reserve Bank. It can no longer be securely held.

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