Fed warns on Economy

NEW YORK (CNNMoney.com) -- The housing finance crisis and spiraling energy costs will remain a drag on the U.S. economy for the rest of the year, Federal Reserve Chairman Ben Bernanke told lawmakers on Tuesday.

"Many financial markets and institutions remain under considerable stress, " according to Bernanke's prepared testimony.

The Senate Banking Committee was meeting to hear from Bernanke about the economy and to consider the crisis at mortgage finance giants Freddie Mae and Freddie Mac, as well growing fears about bank failures.

Bernanke said the financial sector's problems are not the only problems facing the economy and warned "the financial headwinds on spending and economic activity have been compounded by rapid increases in the prices of energy and other commodities."

He said the combination of rising commodity prices and tighter credit "has sapped household purchasing power even as they have boosted inflation."

As he prepared to give the testimony, shares of Fannie and Freddie continued their recent slide that has prompted the Treasury Department and the Fed to step in and offer support in recent days.

Shares of Fannie (FNM, Fortune 500) plunged 22% in early trading. That came on top of the 48% decline it has seen in the last six trading days. Freddie (FRE, Fortune 500) shares tumbled 27% on top of its 51% slide in the last six days.

Bernanke prepared remarks come as part of his regularly-scheduled semi-annual testimony on the state of the economy. At 11:30 a.m. he is due to be joined by Treasury Secretary Henry Paulson and Christopher Cox, chairman of the Securities and Exchange Commission.

Mortgage finance giants Fannie and Freddie are a key source of funding for banks and other home lenders. Their ability to provide that funding is seen as a key to any recovery in housing and the economy as a whole.

The companies were set-up by Congress, but they are owned by shareholders, who have fled the firms' stock recently on fears that continued problems in housing and rising mortgage defaults will force them to seek significantly more capital, a move that would dilute the value of existing shares.

Problems in the banking and home lending sectors were further highlighted by the failure of IndyMac, a California bank that was taken over by the federal government Friday evening in what could end up being the most costly bank failure in U.S. history. Stocks of many major regional banks plunged Monday on concerns over further failures and several were down again in pre-market trading Tuesday.

IndyMac had been a major provider of mortgage loans that did not demand lenders to provide full or any documentation of their income. There are likely to be questions about the state of banking and the risk of more failures at Tuesday's hearings.

Sunday evening Paulson announced a proposal by Treasury to have Congress raise the $2.25 billion it is allowed to loan the two firms, and even open the door for the federal government to buy shares in the two companies if needed. The Fed announced it stood ready to loan money to the firms if they needed access to funds ahead of congressional actions.

Just three weeks ago the Fed left interest rates unchanged for the first time in nine months as it said the risks of an economic slowdown appear to have diminished. But it warned at that time that tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters