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Will the real estate collapse cost America $8 trillion?

Posted Jul 22nd 2008 6:00PM by Peter Cohan
Filed under: Federal Natl Mtge (FNM)

The New York Times reports that the cost to bailout Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) could hit $25 billion. But that cost dwarfs what the collapse of the real estate market might cost our country in total. I think $8 trillion is a reasonable estimate -- that's about 56% of our $14.2 trillion Gross Domestic Product (GDP).

Why are we talking about a taxpayer bailout of these two government sponsored entities (GSEs)? After all, shareholders own them but there's some vague notion that since they're GSEs, government should bailout the investors who bought their $5.2 trillion worth of mortgage-backed securities (MBSs).

So how did the government pick the $25 billion figure? It turns out that the Congressional Budget Office (CBO) doesn't know how much the bailout will cost. So it is developing different scenarios. One suggests that a bailout will cost nothing. Another suggests that there's a 5% chance that the bailout will cost $100 billion. I think this means that the bailout has an expected value of $5 billion (the chance of the scenario times its cost). Regardless, the CBO's $25 billion looks like it will be joined by an estimate that follows the Fed and OCC's look at the books of Fannie and Freddie.

I commend the CBO for doing some analysis. The Times reports that the CBO found that although Fannie and Freddie had $55 billion in capital on an accounting basis; their net worth on a liquidation basis -- if they had to sell their assets and pay off their liabilities -- would be a mere $7 billion, a thin cushion considering liabilities at the time of $1.6 trillion. The point is the agencies that were supposed to be regulating Fannie and Freddie fell down on the job.

Where will we get the money? The same place we've been getting it all decade -- more borrowing, The Times reports that the current debt limit is "$9.815 trillion and outstanding federal debt is roughly $9.5 trillion, leaving a cushion of $310 billion." No doubt the White House will argue that we need to borrow more -- roughly twice where we were at the beginning of the decade.

Unforunately the collapse of the housing market in the U.S. has far greater costs. The loss in the value of the housing stock has been estimated so far at $6 trillion -- but that figure could go higher. Then there's the $400 billion that banks have written off so far due to dodgy MBSs on their books -- and that figure is expected to hit $1.6 trillion. Add in the pain from three million foreclosures and the layoffs from people who work in construction and you're creeping up to $8 trillion.

That's a pretty deep hole for the next President to crawl us out of.

Update. A Houston ABC affiliate has a clip of the current President making light of the problems. As he says in the clip: "There's no question about it. Wall Street got drunk ---that's one of the reasons I asked you to turn off the TV cameras -- it got drunk and now it's got a hangover. The question is how long will it sober up and not try to do all these fancy financial instruments."

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.

Tags: congressional budget office, congressional budget..., CongressionalBudget..., CongressionalBudgetOffice, fannie, fannie mae, fannie maefreddie mac, fanniemac, FannieMae, FannieMaefreddieMac, freddie mac, FreddieMac, inthenews

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