Bankrupting Uncle Sam

Trying to make sense of the financial mess that the sub-prime mortgage crisis has created leaves me feeling like the guy who looks up and realizes that he’s painted himself into the far corner of the basement. He’s got options, sure, but some are messy and none are pleasant.

Let’s look at the most likely outcomes of this week’s near-collapse of Fannie Mae and Freddie Mac, two companies that own or have guaranteed $5 trillion worth of mortgages, about half of all outstanding home loans in the United States.

Sit in the corner and wait for the paint to dry. This could push the U.S. into a full-blown depression. If former Fed governor William Poole is correct and Fannie Mae and Freddie Mac are insolvent, then available cash for home mortgages in the U.S. dries up. Housing prices collapse as the pool of mortgage money dries up,

Walk across the wet paint to get out. An infusion of cash from the public sector, maybe in the form of a loan, a guarantee to bondholders, or through the purchase of a large bloc of voting equity, could possibly provide the liquidity to float Fannie Mae and Freddie Mac over this rough patch. It would tax an already stretched federal budget, but at least taxpayers might get something back down the road.

Bust out the basement wall, mount a rescue, and then build a new, bigger house around the painter (with public money). This is probably the least likely option in the short term because it’s an election year. It’s hard to imagine either major party endorsing the simplest and most direct solution until after November: Nationalizing Fannie Mae and Freddie Mac. What this does, in effect, is make official the unofficial reality: Fan and Fred are not just Government-Sponsored Enterprises, they’re government-backed entities.

Call me cynical, but I wouldn’t be surprised to see this as the ultimate solution. The money men who created this mess by packaging mortgage loans as investment-grade financial instruments have too much at stake. And once again, the American taxpayer will be on the hook. The estimated $1 trillion price tag dwarfs the bill we paid to clean up the savings and loan collapse of twenty years ago.

Worse, assuming the $5 trillion in liabilities on the books of Fannie Mae and Freddie Mac would essentially increase the national debt by about 50% overnight. This could result in a downgrade of the Treasury’s AAA credit rating, which would in turn raise the cost of borrowing money to finance government functions. That would further squeeze government budgets already strained by declining property and sales tax revenues.

All in all, we’re heading into uncharted waters — or at least, waters we haven’t sailed since 1929.

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