By Rick Newman , On Wednesday January 13, 2010, 5:43 pm EST
In the cast of corporate characters, Fannie Mae and Freddie Mac are A-list villains, thanks to the central role they played in the 2008 financial meltdown. The two mortgage-finance firms failed as spectacularly as AIG, the poster child for finance-gone-wrong, with the combined Fannie-Freddie rescue totaling about $111 billion so far--the biggest bailout of all. Both firms are effectively nationalized, and the government would probably wind them down except for one thing: They underwrite about three quarters of all the mortgages issued in the United States.
You've probably heard that the economy is recovering, that consumers are more optimistic, and that companies might soon begin hiring more workers than they're firing. Hooray. We'll all be thrilled when the economy stops quivering. The only problem with an upbeat prognosis is that large chunks of the U.S. economy remain addicted to financial painkillers or dependent upon dysfunctional institutions like Fannie and Freddie, and we've never gone through the kind of withdrawal that's set to take place this year. If all goes well, we'll avoid messy complications, such as these:
Housing tanks all over again. It's hard to believe the housing market could get any worse, with prices already down by more than 30 percent from their 2007 peak. On the other hand, it's astounding that housing is as bad as it is, considering the massive amounts of government aid that have been transfused into this comatose market. In addition to subsidizing the entire mortgage market via Fannie and Freddie, the government has also stepped in to buy billions in mortgage-backed securities--replacing private investors who are sitting on the sidelines--to keep money flowing to consumers. Then there are the tax breaks meant to spur demand for homes and other programs to reduce foreclosures and arrest the plunge in prices.
The tax breaks expire this year, and the government probably can't afford to extend them (again). The Federal Reserve and other agencies have also said they'll begin an orderly withdrawal from housing finance in 2010. Most forecasts call for a spike in foreclosures and further price declines in the first half of the year, with a possible bottom and tepid recovery in the second half. But it's far from clear what will happen when the government aid dissipates. Will that remove one leg from the chair? Two? Three? If the private markets don't fill the void left when the government backs out, it could trigger a fresh crisis that inflicts more collateral damage on the rest of the economy.
Stocks crash. An epic bull rally since the lows of March 2009 has probably been the single biggest contributor to the so-called recovery. Though stocks are still down from their October 2007 peak, the rebound has eased a sense of panic and helped restore some of the household wealth lost in the housing bust (for those lucky enough to have stock-market investments and to have stuck with them through the bottom). And that's probably been a big factor helping consumer spending to recover. But while stocks have been surging, jobs have continued to disappear, and this divergence between Wall Street and Main Street must end. The conventional view is that stocks foretell a pickup in the "real economy," which will follow the market's recovery after a lag of some length. But what if it's the moribund job market that exerts the stronger gravitational pull, dragging down stocks? If so, buckle in for a double-dip.
There's a U.S. debt crisis. Assuming the economy stabilizes, this is also the year that President Obama will start to talk tough about reducing America's $8 trillion public debt, which amounts to more than half of our total economic output. There will be careful efforts to make sure that no deserving American feels any pain (the rich don't count as deserving) and that Congress passes no unpopular measures that would get anybody unelected. The financial markets might buy this, allowing our government to keep borrowing and keep spending beyond its means. Or the markets might decide that America is heading toward bankruptcy and dump the dollar, forcing the world's biggest debtor nation to pay higher rates on its securities, slash spending, and hike taxes. We should probably just relax, confident that Washington politicians always rally to head off devastating problems before they explode.
Consumers become rational. Given the painful transformation of the U.S. economy, Americans ought to be saving like crazy and buying nothing they don't need. Some are, but it's not clear yet if Americans as a whole will save more over the long term or go back to spending nearly everything they have. The savings rate has crept up to about 5 percent, but that's still lower than the long-term average and far lower than you might expect after a collapse like the one we've endured. If savings continue to go up--a prudent move for most households--consumer spending will come down, leaving a hole in the growth of our gross domestic product, with little else to fill it. So hopes for a vigorous rebound rest on spendthrift consumers being as materialistic as ever. Now there's a strong foundation for success.