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Meltdown Risk, Revisited

Author: Lee Hudson Teslik
July 16, 2008

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The troubles faced by the U.S. mortgage-lending behemoths Fannie Mae and Freddie Mac are no small matter. The two lenders hold or guarantee over $5 trillion worth of U.S. mortgages, about half the country’s mortgage market. Should they collapse—an outcome which seemed a real possibility the morning of July 11 when shares of the firms nosedived almost 50 percent—they would sap credit (FT) from the already gummed-up U.S. housing market. This in turn could wreak havoc on real-estate prices, bringing another wave of mortgage defaults, and could spell major trouble for already embattled financial institutions, many of which have invested in mortgage-backed debt.

A scenario in which the U.S. government saves Freddie and Fannie by nationalizing them isn't much rosier (Economist). Such a move would increase the U.S. budget deficit by nearly 50 percent and could prompt a rapid decline in the dollar's valuation against other currencies. The U.S. Treasury, skirting the buyout option, acted to stop the bleeding with a plan that treats the mortgage lenders like banks and gives them access to the Federal Reserve's discount window for emergency loans. President Bush called the plan a temporary measure to stabilize markets, and urged Congress to act quickly to pass it. Fannie and Freddie, meanwhile, quickly seized on provisions that let them offload assets (Forbes) onto the U.S. Federal Reserve. The strategy didn't do much to allay market fears, however, and stocks tumbled globally (FT) in the days following its announcement.

The broader question now is what Fannie's and Freddie's woes might mean for U.S. and global growth. Testifying before Congress on July 15, Federal Reserve Chairman Ben Bernanke gave a downbeat assessment, saying a combination of inflation, energy prices, and financial instability will continue to plague economic growth and could spell a further slowdown.

The most urgent concern in the short-term is that falling real estate prices and mortgage defaults—the factors leading to Fannie's and Freddie's woes—could bring down yet more financial institutions. On July 11, the California bank IndyMac (no relation to Freddie) became the seventh U.S. bank to fail since the credit crisis started, and one of the biggest bank failures in U.S. history. The specter of a bank run emerged as customers queued outside branch offices (LAT). With quarterly earnings season well underway and analysts expecting ugly results from financial institutions, news reports indicate Wall Street is increasingly concerned about the possibility of a wave of bank failures (USNews). Such problems would extend well beyond U.S. borders, given the extent to which international banks invested in U.S. debt—not to mention the geopolitical ramifications of a falling dollar.

If there's a silver lining, experts say, it is only that markets have already factored in a lot of financial pain. Some financial analysts are starting to wonder whether, with markets in full freak-out mode, equities may finally be looking more palatable (WSJ). Others have noted that the problems currently faced by financial markets don't necessarily mean (Times of London) underlying economic problems. Rapid economic growth in many parts of the developing world still carries the possibility of mitigating global economic distress—though inflation in many of the same countries (Economist), combined with a more reticent U.S. consumer, could yet undermine this growth. So too could U.S. inflation, which continues to bubble upward in line with gravity-defying oil prices. None of this necessarily foretells a meltdown, economists say. But, as Bernanke said in his July 15 testimony, the present economic environment seems "unusually uncertain."

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