Now the Revival Can Begin

The Paulson-Bernanke support package could start the process of restoring the markets

It looks as if the rest of 2008 is going to be painful. More bank closings will almost certainly follow the failure of IndyMac Bancorp. Home prices are likely to keep slipping, profits will plummet, and unemployment will rise.

But despite the bad news, the credit crisis may finally have reached its climax. Why? The enormous step taken on July 13 by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. They proposed a support package for mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), including a higher credit line from the government, access to the Fed's discount window, and possible stock purchases.

It's not clear yet if Congress will approve the plan. But the announcement alone has broken a critical barrier by explicitly acknowledging the government's responsibility for Freddie and Fannie. That makes it much more likely that there will be a full-scale bailout of the housing sector under the next President. By this time next year we could see a reinvigoration of the financial markets, boosting not just housing loans but borrowing for business investment and infrastructure.

Until July 13 no one was certain what would happen if Fannie and Freddie got in trouble. For example, Fannie's 2007 annual report said "the U.S. government does not guarantee, directly or indirectly, our securities or other obligations."

But now Paulson and Bernanke have effectively placed the full faith and credit of the U.S. government behind the two companies. Buyers of Freddie and Fannie's securities can now reasonably assume that their investments are as safe as Treasuries.

However, it's not sustainable for Fannie and Freddie to conduct business as usual with a full government guarantee. For one thing, other companies that don't have similar protection will complain bitterly. Second, taxpayers will be on the hook for any bad decisions Fannie and Freddie's executives might make.

Politically it will grow harder and harder to resist the next step—some sort of takeover of Fannie and Freddie by the government—especially if losses mount. Nothing will happen until after the Presidential election, of course, because neither the Republicans nor the Democrats want to be the first to suggest using massive amounts of taxpayer money in this way. But the next President will take office in a weak economy, and his first official act may be a bailout that not only rescues Fannie and Freddie but also buys up bad mortgage debt from banks and helps homeowners.

How big would that bailout have to be? Morgan Stanley (MS) economists estimate that mortgage losses will total $500 billion. That's a lot of money. But when the government bailed out the saving-and-loans in the 1980s, roughly two-thirds of the originally announced losses eventually were recovered. If the same ratio holds this time, then the ultimate cost to taxpayers would be about $160 billion—the same size as the current stimulus package.

For their money, taxpayers would get a bailout that puts a floor under the housing market and stems the tide of foreclosures. Moreover, the financial sector would no longer be struggling under the weight of bad debt. That would help not just housing but other sectors such as business investment and borrowing by government for infrastructure. In fact, the combination of the need to pump up a weak economy and the need to upgrade U.S. roads, bridges, rails, power lines, airports, and water systems could usher in a golden age of infrastructure construction.

Despite itself, Washington is finally starting to come to grips with the problem. And that's the best news we've heard in a while.

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