Fannie and Freddie, the economy, and the election

Posted on September 7, 2008


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.

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