Fannie and Freddie, the economy, and the election

In case you haven’t heard, Treasury secretary Henry Paulson announced this morning that the Treasury was taking over government-sponsored mortgage giants Fannie Mae and Freddie Mac.

To get an idea of just how bad this could be, let’s first look at how our economy is doing right now:

Obama Pictures and McCain Pictures

That’s the last little bit of levity we get out of this issue, I’m afraid.

According to the Bureau of Economic Analysis (BEA)</a., the gross domestic product (GDP) of the United States in 2007 was $13.8075 trillion, up 4.8% from 2006. According to the Bureau of Labor and Statistics consumer price index data, inflation in 2007 for all items (including food and energy) was 2.8%. This means that real economic growth was only 2.0% – GDP growth minus inflation. In the first six months of 2008, inflation rose 6.4% while GDP rose only 1.7%. This means that the economy shrunk by 4.7% in the first half of 2008.

Now let’s look at Fannie Mae and Freddie Mac. Their combined mortgage debt is about $5.4 trillion. According to a BusinessWeek article last month, Fannie and Freddie combined need to refinance $250 billion in debt this month and there’s about $19 billion in outstanding debt at risk now that Fannie and Freddie have been taken over. If you look at their combined exposure as a result of defaults in the sub-prime and Alt-A mortgage (better than sub-prime, worse than prime) markets. As of July, Bloomberg reported that mortgage bankers had lost $435 billion, with more recent estimates suggesting that total worldwide losses could be as high as $2 trillion, of which about half would be in the U.S. alone. If the U.S. is expected to see about $1 trillion in sub-prime and alt-A mortgage losses, that means $500 billion of losses at Fannie and Freddie alone, since they own half of the U.S. mortgage debt.

Half of which is due for refinancing this month.

$500 billion is the estimated amount of exposure that taxpayers have in any potential bailout of Fannie and Freddie. That’s about 3.5% off the U.S. economy. If the Treasury is forced to bail out all of that debt, that will have a huge negative economic impact. Here’s some rough numbers.

Let’s assume that total inflation continues rising at the average of the last 12 month’s inflation, 5.6%. Let’s further assume that GDP continues growing at the average of the last 12 months, or 4.8%. Now, let’s assume that all $500 trillion of Fannie’s and Freddie’s losses (assuming they don’t continue to rise, which they very well may) have to be written off (bailed out) over the next year. That’s another 3.5% negative to the economy. Add the bailout and inflation together and subtract from the GDP and you have a contraction in the real size of the economy of 4.3%. If inflation stays as high as it did in the first six months of 2008 (6.4%), then the economy will shrink by 5.1%.

That’s worse than 1980, which saw the U.S. economy contract 3.7%. 1979 only saw a 1.6% contraction. The most recent year that had greater economic contraction than the estimate above was 1946 (-18.5%). All of the other years were in the 1930s (1932 saw -13.0%, 1931 saw -6.8%, 1930 saw -5.6%, and 1938 saw -3.5%). In case you don’t remember your history, the 1930s saw the Great Depression, and it was World War II that ultimately pulled the United States out of the Great Depression.

Now, let me see if I can put this further into perspective. Right now, the United States is spending approximately $100 billion per year occupying Iraq, or 0.7% of the last 12 months of GDP . Most industry experts believe that we’re at peak oil (for political reasons if not actual supply), and so oil prices are going to continue rising over the long term, essentially boosting inflation permanently. The largest scientific study ever performed (the IPCC’s Fourth Assessment Report on the science of global heating) says that the climate is going to get dramatically worse, and the Stern economic report for the UK government suggests that we’ll need to apply approximately 2% of global GDP every year for the next 100 years or so to adapt, mitigate, and reverse the effects of increasing greenhouse gas concentrations. And if this economic contraction lasts longer than another 12 months, and it well may, then pulling us out of it will take either a New Deal or another total economic transformation like the war footing the U.S. was on to win World War II.

Now, given these downright ugly facts and figures, we have to ask ourselves a couple of absolutley critical questions:

  • Who do you trust to guide the economy through what will likely be its worst contraction since the end of World War II or the Great Depression?
  • Assuming we don’t want another actual world war to boost our economy, who do you trust to lead us through the kind of economic transformation I mentioned above?

I’ll be voting for Obama, by the way.

10 replies »

  1. Actually, this takeover has had major market implications this afternoon and evening. The worldwide markets have responded to the bailout with glee. Right now, the Asian Markets are up 3%, and the S&P futures are up the largest one session move since the year 2000.
    That being said, despite the fact that anyone with a 401K and real estate will end up making money because of this, I oppose government intervention in markets. Now, the auto companies want loans…..who knows who’s going to be next at the trough of government benevolence.

    The government, all governments, should allow free markets to determine what enterprises and markets will succeed or fail. A bailout of this magnitude is akin to putting a band aid on a severed limb. Allowing failure might cause immediate pain, but the will allow for the inefficiencies to be corrected, and assets to be properly valued.

    My proprietary numbers show a 45% chance that we might be in for a round of deflation in the next 8 quarters, it all depends on the M2 money supply figures.


  2. I generally don’t worry about what the market’s going to do over the course of a single day or even most weeks. Just because the stock markets have responded positively doesn’t mean that the long term damage to the economy over the next 12 months or more from a bailout is a good thing. I guess the only real question is whether the damage would have been greater with or without a bailout, and frankly, I just don’t know the answer to that. Obviously the Tresury, FAHA and Fed all thought so, but since they didn’t put out the numbers behind their decision (that I could find), I can’t say for sure one way or another.

    The question is just how much money will the feds have to dump into paying off Fannie’s and Freddie’s bad mortgage debts, and I don’t know. I used numbers from economists above, but I’m not sure they really know either. I hope their $2 trillion number is better than a WAG, but it may not be. We’ll see.

  3. So Freddie and Fannie are now nationalized, did i get that right? Are we a socialist country now? If so, can i have some damned health insurance?

    One more question: who’s going to buy a bunch of debt that has a very good chance of being defaulted on? I sure hope that we can count on the Chinese.

  4. Thanks for this clear, if troubling explanation, Brian. I’ve sold one house and am selling another in this economic wasteland. Looks like I can look forward to happy days being here again.

  5. Jim,

    Surely, you live in such a desirable area that you have to beat buyers off with a stick?


  6. Golly……..if we’re in for 8 quarters of deflationary economy, how will we pay for Dubwah’s
    multimillion dollar presidential library ? Maybe, instead of all those expense books, we can
    fund a presidential weedwacker museum or leafblower museum replete with low wage
    illegal aliens to demonstrate his favorite Crawford pastime. Ciao, Bambinos !

  7. Ron Janesh,
    Are you the 98G2LRU Russian linguist, Wobeck Det (Radenbeck for awhile if memory serves), summer of ’73, Schöningen Schwimmbad “50m laps in the hail” Ron Janesh? If so, guy, it is time to re-connect. It’s only been 35 years! Please email me at dan underscore yz at juno dot com or call me at work, Lesman Instrument Co, you can find it on the web. But please leave a phone number!

    Dan Weise