The Real Cost of a Full Bailout

The CBO recently put taxpayer losses for the Fannie and Freddie bailouts at $25 billion. Don A. Rich finds this number laughable – and the figure he presents may give you nightmares.

A recent study from the Congressional Budget Office (CBO) has zero credibility. It pegged likely taxpayer losses in the Fannie Mae and Freddie Mac bailouts at $25 billion. For those with a sense of history, it is worth remembering that the S&L bailout had a $160 billion price tag. The numbers diverge so far from reality as to be laugh-out-loud funny. Funny, that is, except that the CBO estimate demonstrates a willful disconnect with the actual consequences of federal government actions.

As demonstrated below, the real cost of the bailouts will easily exceed $1.3 trillion. In fact, the real cost is likely to range between $1.3 trillion to $1.6 trillion, and is not unlikely to reach $2.5 trillion.

Between 2001 and 2007, Fannie and Freddie purchased or guaranteed $700 billion of Alt-A and subprime loans. Given the default rates on these loans – and the fact that the price of the housing that is the ultimate security of the loans will, for reasons demonstrated below, fall by at least thirty percent – this alone implies a loss for Fannie and Freddie on the order of $210 billion.

Fannie and Freddie acknowledge already-impaired loans on the balance sheet of $19 billion, which they have used creative accounting to avoid deleting from the shareholder equity account. This means that Fannie and Freddie have a maximum of $64 billion in capital remaining.

Given the inevitable losses on the Alt-A/subprime portion of their portfolio, it must be the case that if the federal government, as it is doing, guarantees Fannie and Freddie’s solvency, the difference between the loss and the capital to be made up by the government (i.e., the taxpayers) must equal, not $25 billion but $147 billion.

That alone would mean that the CBO is blowing smoke with their estimated cost figures, and if you think back to the S&L cost of $160 billion, this is not a surprising result. The real picture is so much worse that it is pretty obvious the CBO is flat out inventing figures just to get the politicians through November.

The real story is simple. We have witnessed the largest asset-price bubble in US history, making the tech-stock bubble seem like an overdone weekly rally.

When you look at the graph of the Case-Shiller residential real-estate index, an index dating from 1890 to the present and an index which measures the cost of housing in comparison to other goods, the first thing you see is that the 2001 to 2006 bubble stands out like a fifty foot saguaro cactus in a patch of daisies. There simply has never been

When you know what you are looking at – the biggest bubble in history – it is scary.

To be precise, the Case-Shiller Index in its entire 110-year history had never crossed 140 until the recent bubble. In 2006, it reached 210. Every single real-estate bubble in the past has at best been followed by a fall back to at least the 110 level in the postwar era, although the bubble preceding the Great Depression witnessed a fall to 60.

What this means is that in the best-case scenario, real-estate prices have to fall in the medium to long run by almost half.

Now consider Fannie and Freddie. Just looking at their portfolios on the balance sheet without the guarantees, let us accept (for no particular reason other than a desire that the reader sleep better at night) that real-estate prices only fall by thirty percent.

Well, since Uncle Sam is now committed to "doing whatever it takes," that is a loss right there of $1 trillion. This commitment to keep financial markets open as usual is made in spite of the overwhelming evidence that what we have been taught is usual is in fact delusional, given that Fannie and Freddie own $3 trillion and change of mortgages.

The CBO is not fence-post stupid, so obviously just as in the S&L fiasco in 1988, they are outright inventing figures so that the politicians can slither into November and then announce, Whoops! our numbers were a little low.

The more realistic scenario is actually worse. Fannie and Freddie own and guarantee a total of more than $5 trillion in mortgages.

Given the long-run historically plausible equilibrium values of residential real estate as embodied in the Case-Shiller Index, that means that the taxpayer loss definitely reaches $1.3 trillion, easily ranging up to $1.6 trillion.

Unfortunately, that is the good news. The bad news is that if real-estate prices were to replicate the Great Depression (as would surely occur in the case that hedging instruments of Fannie and Freddie were to catastrophically fail due to counterparty failure – and given the absurdly low risk premiums on credit-default swaps at the height of the bubble, such an event cannot be considered unlikely) the Case-Shiller Index tells us that the loss to the taxpayers could exceed $2.5 trillion dollars.

I don’t know what those people in Washington are taking to sleep at night after all their electorally driven accounting and finance exercises, but I can tell you what they will be doing to keep the government open for business: printing a whole lot of money.

Chairman Bernanke has the discount window open to any collateralization not worth the paper it is written on, so in effect he has the helicopters ready to drop hundred-dollar bills over Wall Street – as he once famously described the ultimate policy instrument of a fiat-money system.

Of course, if he does that, we will have to change his nickname from Helicopter Ben to Hyperinflation Ben, which answers the question of who picks up the tab of bailing out Fannie and Freddie: anyone owning dollars.

Produce a lot of something, and it becomes worth less. And given the losses at Fannie and Freddie, the taxpayer guarantee, and the ongoing initiation of Boomer retirement, only the inflation tax will work to pay for keeping Fannie and Freddie afloat.

Like it or not, we are about to enter interesting times, and it is too bad our supposed professional civil servants at the Congressional Budget Office have failed to tell the emperor the truth: that he is buck-naked bankrupt and getting ready to take a lot of people with him.

Our only hope is to (1) accept up front a twenty-percent fall in American living standards for a people living beyond their means for the past twenty-five years on the delusions made possible by fiat money, and (2) simultaneously discipline the creature from Jekyll Island, a.k.a. the Federal Reserve System, not to create new money just to prop up asset-price bubbles.


Don A. Rich
for The Daily Reckoning
September 04, 2008

Don A. Rich is an instructor of economics, finance, and political science at Montgomery County Community College in Blue Bell, PA. He also teaches economics, government, and history at Delaware County Community College in Exton, PA.

Not much action in the markets yesterday…but we don’t have any time to reckon with it anyway.

Gold plunged all the way down to $806. Now analysts are starting to talk about oil below $100 and gold below $750.

Meanwhile, Goldman Sacks predicts that oil will go all the way back to $149 before the end of the year.

Go figure.

We don’t know. The markets can do what they want, as far as we’re concerned.

But what if you have money you have to do something with it. What do you do?

Avoid U.S. stocks. The U.S. market is in relative decline. And it’s just going to get worse from here…

Avoid U.S. bonds and the U.S. dollar too – they’re both too dangerous. Besides there’s no margin of safety. If everything goes right, you won’t earn very much. If it goes wrong, you’ll be wiped out.

Buy gold. We don’t know what direction it is going, but it isn’t going away. And if the world’s monetary system is troubled – either by inflation or deflation – gold will be good protection. Consider it an insurance policy. You pay for fire insurance on your house. If your house doesn’t burn down you still don’t regret having paid for fire insurance. If everything goes right in the world economy, gold will probably go down further. But if anything goes wrong – and our guess is that something will go wrong – you’ll be happy to have some Krugerrands in your pocket.

And buy Indian stocks. (More about this tomorrow…now, we’ve got to get back to our conference…)

*** We’re back in the U.S.A. Impressions? People are still driving big cars. The shopping malls are still open. There’s no obvious sign of decline.

Driving up from Dulles Airport in Northern Virginia, there are the same office buildings – mostly companies that thrive on military contracts – and there are still traffic jams in the late afternoon on the Washington, D.C. beltway. The lumpenconsumer is still spending money (reports suggest that the English are cutting back on spending faster than Americans)…and he’s still convinced that this is just a temporary setback, not a genuine turnaround. The boom is eternal, he believes.

Our guess is that the eternal boom has come to an end. At least, the credit boom thant began in ’82 has come to an end. Credit has tightened. Real rates of interest will be going up. Fear will replace greed as the dominant emotion. And saving will replace spending as the trendy thing to do with your money.

It’s still early in the cycle (these cycles last a generation)…but we will stick to our hypothesis until proven wrong…or until we go broke.

*** Even though we are still seeing SUVs on the road – gas prices be damned! – Americans simply aren’t buying new trucks. In fact, Detroit’s "Big 3" – GM, Ford and Chrysler – reported monthly declines of at least 20% since last year. Layoffs, plant shutdowns and major cutbacks have become the norm in the domestic auto industry.

With more and more Americans purchasing hybrids and more fuel-efficient vehicles, these plants need an overhaul to keep up with the technology of their competitors…and that’s going to take some serious dough.

Now, taking a page out of Fannie and Freddie’s book, the Big 3 are looking to the government for a $50 billion loan. Both presidential candidates are on board (a great way to buy some votes auto-dependent Midwestern states) and the Bush administration is "thinking about it." Experts are putting the chances of this package being passed by Congress at 75%, citing a perfect storm of circumstances: plunging auto sales, high gas prices and election year politics.

What the outcome of this bailout will be is up for grabs. Some think $50 billion won’t do much to help this troubled industry, and others believe that this will help the companies get back on their feet, up to speed with the trends, helping them in the long-term.

What is abundantly clear from this situation is that the consequences of the country’s EZ credit policies are rearing its ugly head. Steven Pearlstein, writing for the Washington Post:

"Can we be assured that, after the Big Three, no other industry will step forward and demand that the government rescue it from its own misjudgments? Unfortunately not. This is what happens when asset bubbles develop, countries live beyond their means – and then, inevitably, the bubble bursts and economic reality finally reasserts itself. Now the bill is coming due. The only thing left to be resolved is how it will be paid."

More to come…

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning