Best- and worst-case economic scenarios

By Peter Coy

updated 8:54 a.m. ET Sept. 12, 2008

O.K., we've finally wrapped our minds around the impossible: On Sunday, Sept. 7, in the name of preventing a financial meltdown, the conservative Bush Administration announced that it was seizing control of two of the nation's biggest and highest-rated (until recently) financial institutions, the mortgage giants Fannie Mae and Freddie Mac.

In short, pigs can fly, and hell really can freeze over. So maybe it's time to expand our sense of the possible and ask what other shockers are in store.

Will the 13-month-old credit crunch get even worse and drag down the entire global economy? Or are punch-drunk Americans due for an even bigger shock, namely some good news for a change?

The financial markets are grappling with just those issues — and gyrating between euphoria and panic. Stocks climbed on Sept. 8, the first trading day after Treasury Secretary Henry M. Paulson Jr. announced that he was placing Fannie and Freddie under federal conservatorship. The Standard & Poor's 500-stock index rose 2 percent. But the next day, fears that venerable investment bank Lehman Brothers might go under dragged the S&P 500 down 3.4 percent.

In highly uncertain times like these, scenario-spinning can be an excellent tool for making sense of conflicting data. It won't guide you straight to the right answer, but it will get you thinking about the right questions to ask.

Best case scenario
For a best case, imagine a virtuous circle of events that starts with a favorable market reaction to Paulson's putsch. Paulson promised to replenish the companies' capital by purchasing up to $100 billion in senior preferred shares in each, as needed, to make sure they retain a positive net worth. He also set up a secured lending facility that they can draw on if their private funding sources get too costly.

And he said Treasury itself will try to make mortgage loans more available and affordable by buying Fannie and Freddie mortgage-backed securities, starting with a token $5 billion but possibly going far higher.

More from Businessweek.com Uncle Sam saves Fannie and Freddie Bartiromo: Paulson on housing bailout, next steps Fannie and Freddie's open-ended future

Paulson's move made a big impression in foreign markets, which have been nervously eyeing the condition of American banks. On Sept. 10, at a conference in Germany titled "Banks in Upheaval," Deutsche Bank CEO Josef Ackermann argued that "we are in a period of stabilization in credit markets and in stock markets, although they still remain nervous." Ackermann added: "We believe that what we see is the beginning of the end of the crisis."

At the very least, Paulson's unprecedented move defuses one ticking time bomb. It decreases the chance that either Fannie or Freddie will default on its debts or credit guarantees, which was the doomsday scenario for global financial markets. Together, the two companies have about $1.7 trillion in outstanding corporate debt. In addition, they have guaranteed repayment on $3.7 trillion worth of mortgage-backed securities they've issued.

Those securities are held by risk-averse investors such as banks, pension funds, and central banks around the world. Asian central bankers, in particular, had pressed the Treasury Dept. for action in the weeks before the takeover. Technically, Treasury is not guaranteeing the twins' obligations, but the chance that it would tolerate a default has dropped from small to near zero.

As investors get comfortable with Treasury's terms, the hope is they will settle for lower yields on the mortgage-backed securities Fannie and Freddie package and insure. Indeed, yields on the companies' mortgage-backed securities fell the day after the announcement by about 0.4 percentage points. National average rates on 30-year, fixed-rate mortgages fell by an equal amount between the Friday before the announcement and the Wednesday after, to about 5.7 percent, according to daily surveys by Bankrate.

Unclogging Fannie and Freddie's pipeline could finally make effective the easy-money policies of the Federal Reserve, which has cut the federal funds rate by 3.25 percentage points since the start of the crisis, to a stimulative 2 percent.

MORE FROM BUSINESSWEEK

BusinessWeek Section Front

Google's OS: Will PC Makers Bite? Stocks Finish Mixed as Earnings Loom Junk Bonds: A Rickety Recovery Nortel Gets Interest from MatlinPatterson Stocks Slump on Economic Worries Stimulus: Where's the $787 Billion? Hollywood's New Math: Who Needs Stars? Earnings: Where the Q2 Surprises Could Be Lessons from the Data Breach at Heartland A Second[ary] Chance for Venture Capital BusinessWeek Section Front