By Jason Simpkins
Associate Editor

Now that presidential hopeful Barack Obama has returned from a tour of the Middle East and Europe, he and his Republican rival, John McCain, are squaring off on the status of the U.S. economy, which has become the most pervasive domestic issue in the 2008 campaign.

Obama met with a panel of advisers yesterday (Monday) to discuss possible remedies for the sputtering U.S. economy. That panel included such eminent figures as billionaire Warren Buffett, Paul Volcker, and former Clinton advisor Robert Rubin.

“People are understandably concerned about the economy, and that’s what we will be talking about for the duration,” Obama said Sunday at an appearance in Chicago.

Obama will use the meeting as an opportunity to fine-tune his economic policies which could include a second stimulus plan that would offer another $50 billion of tax rebates and a $10 billion foreclosure-prevention fund. Obama also supports free-trade agreements and said he would reopen the North American Free Trade Agreement (NAFTA).

NAFTA was established in 1994 under the Clinton administration as a means of disarming major trade barriers between the United States, Mexico, and Canada. Free trade was a major issue for then-Treasury Secretary Robert Rubin, whose policies were centered on reducing the federal budget deficit. However, the principles of “Rubinomics” (which were continued by Lawrence Summers, Rubin’s successor and a fellow panelist) were criticized by U.S. labor unions as Wall Street favoritism that exported American jobs overseas. 

Senator McCain, the Republican candidate who has traveled to Colombia, Mexico, and Canada to defend free trade deals himself, will hold a series of town hall meetings in Nevada and Wisconsin in an attempt to drum up support for his economic policies.

“I think that Wall Street is the villain in the things that happened in the subprime lending crisis and other areas where investigations and possible prosecution is going on,” McCain told ABC. The statement echoes President George W. Bush’s assertion last week that Wall Street “got drunk.”

McCain also pointed his finger at Congress for a mounting U.S. deficit brought about by “out of control” spending. He has also sought to portray Democratic opposition as unwilling or unable to combat high-energy prices by playing up his support of a “gas tax holiday” and more offshore drilling. A spokesman for McCain told Bloomberg News that his meetings would focus on the economy and the need for independence from foreign oil.

It’s entirely possible that whomever is elected president will inherit a flagging economy if not an outright recession and a ballooning deficit. The U.S. budget deficit will widen to a record of about $490 billion next year, an administration official said yesterday.

 The next president will also be faced with the question of what to do with Fannie Mae (FNM) and Freddie Mac (FRE) – the insolvent government sponsored enterprises that insure roughly half of the $12 trillion of U.S. home loans.

Both Obama and McCain voiced their support for housing legislation that passed the Senate last week, though both missed the vote.

News and Related Story Links:

• Money Morning:
  Election 2008: The Achilles’ Heel of Obamanomics

• Money Morning:
  Election 2008: Why Poor Presidential Approval Ratings Make For Great Stock Markets

• Money Morning:
  Election 2008: Obama or McCain – U.S. May Suffer Either Way

• Bloomberg News:
  McCain, Obama Put Economy’s Strains at Center Stage

• The Financial Times:
  Obama turns focus to economic policies

Both U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke were called to the carpet yesterday (Tuesday) to explain to Congress how continued turbulence in U.S. credit markets will affect the economy in coming months.

Both ended up backtracking on previous statements, as their ill-conceived cures for the broader U.S. economy were stripped of any relevancy by a tumultuous and unforgiving credit market.

Fannie Mae (FNM) dropped $2.13 a share, or 22% yesterday, to close at $7.60 share. Freddie Mac (FRE) sank $1.77, or 25%, to close at $5.34 a share. The beleaguered mortgage giants dragged the market down with them, as the Dow Jones Industrial Average closed down 92 points, or .84% at 10,962.54. It had earlier fallen as low as 10,840.81. The S&P 500 Index closed at 1,214.91 down 13 points, or 1%.

After saying Sunday that Fannie Mae and Freddie Mac “play a central role in our housing finance system and must continue to do so,” Paulson amended his comments to the Senate Banking Committee, saying his plan “is aimed at supporting the stability of financial markets, not just these two companies.”

“Let me stress that there are no immediate plans to access either the proposed liquidity or the proposed capital backstop,” Paulson added. “If either authority is used, it would be done so only at Treasury’s discretion, under terms and conditions that protect the U.S. taxpayer.”

Similarly, Federal Reserve Chairman Ben S. Bernanke was forced to rethink his previous statements concerning the progress of the economy.

After saying in June that the risks of a “substantial downturn” had diminished and the Fed would shift its focus to resisting “an erosion of longer-term inflation expectations,” Bernanke said before Congress today, that the economy “continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil [and] food.”

Now, as credit markets tighten and inflation continues to strengthen its grip on the U.S. economy, both Paulson and Bernanke have the unenviable task of shepherding the economy through one of the most difficult economic climates of the past century.

Paulson’s Predicament

After opening higher Monday following Paulson’s remarks and a successful sale of short-term debt at Freddie, both stocks resumed their slide with each company falling more than 30% in the past two days. Fannie Mae has lost 81% year-to-date, while Freddie Mac has dropped 84.5%. 

“The impact of Sunday’s announcement by the Federal Reserve regarding its mortgage bail-out plan for Fannie Mae and Freddie Mac remains somewhat derided in the market,” James Hughes at CMC Markets told the Financial Times. ”It has apparently done little more than underline the perilous state of the U.S. economy.”

Both Freddie and Fannie have cash on hand, and both meet their regulatory capital requirements. It also looks as though both firms will also be bolstered by U.S. Treasury Secretary Henry Paulson’s rescue plan, which includes generous credit lines and a pledge by the U.S. government to purchase equity in the companies as needed.

But government assistance notwithstanding, investors and analysts anticipate falling house prices and an increasing number of mortgage defaults will incinerate what little capital the companies have left. Their balance sheets are also highly suspect, though Freddie Mac looks far worse off than Fannie Mae.

At the end of the first quarter Freddie’s balance sheet showed assets of $803 billion and shareholder equity of just $16 billion, CNNMoney reported. That means Freddie has just one dollar in equity for every $50 of mortgages and other assets it holds. The company’s mortgage portfolio is even more disconcerting, as it shows just 70 cents worth of equity for every $100 worth of business on its books.

“Is this enough equity when your business consists of buying and guaranteeing mortgages?” Len Blum, a managing director at New York investment bank Westwood Capital, wrote in a recent report quoted by CNN. “How about when you conduct these activities in markets falling by 20% or more?”

Finally, according to the fair-value balance sheet, which reflects the value of Freddie’s assets rather than their cost, the company’s shareholder equity stands at negative $5.2 billion. Using fair-value accounting, Fannie Mae shareholders are still up $12 billion.

Also, as other lenders have withdrawn from the mortgage market in the face of plummeting home values and a mountain of foreclosure filings Fannie and Freddie have been left to pick up the slack to the point that they are now involved in 80% of U.S. mortgages.

With so much on the line, the failure of Freddie Mac and Fannie Mae would be cataclysmic. And not just for the U.S. market, but for global investors.

Because government-sponsored enterprises (GSEs), such as Fannie and Freddie, offer higher yields than treasuries and enjoy implicit assurances from the U.S. government, they are very appealing to foreign investors who hold approximately $1 trillion in GSE debt.

Indeed, if Fannie and Freddie were to fail, it would undermine these investments and cost international investors dearly.

Bernanke’s 180

The ongoing struggles at Fannie Mae and Freddie Mac also represent an additional hurdle for U.S. Federal Reserve Chairman Ben S. Bernanke. The Fed chair was already struggling to balance sluggish growth and soaring inflation, and now volatility in the credit markets has flared up precisely as the Fed was starting to telegraph a rate increase.

Last month, Bernanke said the risks of a “substantial downturn” had diminished and vowed to “strongly resist” mounting inflationary pressure. Many traders predicted the Fed would raise its benchmark-lending rate as early as August. Wall Street had priced in three interest rate rises from the current level of 2% to 2.75%, according to the Times Online.

But now, those same traders don’t think Bernanke will move before October at the earliest.

“Bernanke has changed his tune,” Kevin Logan, senior economist at investment bank Dresdner Kleinwort Ltd. in New York told the Times. “In June, he said that he didn’t think it was all that bad. Now, six weeks later, he is saying that there are significant downside risks. He has basically been forced to face the data that has come out over the last six weeks, which shows that the U.S. economy is deteriorating.”

In prepared testimony before the Senate Banking Committee, Bernanke said yesterday that the economy “continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil [and] food.”

“Many financial markets and institutions remain under considerable stress, in part because the outlook for the economy and thus for credit quality, remains uncertain,” he added. “In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority."

Inflation’s Open Invitation

With inflation no longer the predominant priority for the Fed, the dollar will continue to weaken and inflation will engulf the economy.

“The Fed is downgrading some of their economic outlook for the medium term,” Carl Forcheski, vice president on the corporate currency sales desk at Societe Generale SA (OTC: SCGLY) in New York, told Bloomberg. “That translates to a continued postponement of any thoughts of rate hikes,” thus weakening the dollar.

The greenback hit a record low of $1.6038 against the euro yesterday (Tuesday), after the Labor Department reported that inflation at the wholesale level jumped 1.8% in June, after climbing 1.4% in May. Consumer prices likely climbed 4.5% in June, according to economists surveyed by Bloomberg.

According to the Fed’s most recent economic projections inflation will be higher this year than previously thought, with prices rising as high as 4.2%. But with financial markets racked with uncertainty, it’s hard to tell how much further the dollar has to go. 

“The reality is the U.S. housing market and credit squeeze haven’t hit bottom yet,” Takuma Kurosawa, global markets treasurer at HSBC Bank PLC (OTC: HBCBF), told Bloomberg. “That’s discouraging investors from holding dollar assets.”

Paul Robson, a currency strategist at Royal Bank of Scotland Group PLC (ADR: RBS) told the International Herald Tribune that the euro would hit $1.62 in the “near term,” but a sharp rise to around $1.65 would spur intervention by global central banks to support the greenback.

The diving dollar did little to save foreign markets, however, as fears about the U.S. economy infiltrated global markets.

In London, the FTSE 100 index fell 2.4%, while the Dow Jones Euro Stoxx 50 index dropped 2.3%. The CAC 40 in Paris and the DAX in Frankfurt each lost roughly 2%.

In Asia, the Hang Seng index in Hong Kong fell 3.8%, taking its loss for the year to 24%, while the Nikkei 225 stock average fell nearly 2%.

News and Related Story Links:

• Money Morning:
  As Treasury’s Paulson Prescribes Bailout for Fannie Mae and Freddie Mac, Guru Jim Rogers Predicts an “Unmitigated Disaster”

• CNNMoney:
   Freddie Mac under attack

• Times Online:
  Bernanke offers grim outlook for state of US economy

• Bloomberg:
  Dollar Falls Most Against Yen Since March on Bernanke’s Remarks

• Bloomberg:
  Bernanke Forecasts Foiled by Fannie-Freddie Rescue

By Jennifer Yousfi
Managing Editor

There’s more bad news ahead for the U.S. economy as home foreclosures continue to rise.

One out of every 483 U.S. households is at some stage of the foreclosure process, and with that many displaced or struggling homeowners, the economic recovery may well take longer than expected.

“May was the third straight month where we’ve seen a month-to-month increase in foreclosure activity and the 29th straight month we’ve seen a year-over-year increase,” James J. Saccacio, chief executive officer of RealtyTrac, said in a statement.

Home foreclosures jumped 7% in May from April and are up a whopping 48% year-over-year with 261,255 filings this past month according to RealtyTrak’s U.S. Foreclosure Market Report. That figure includes all homes that either received default or auction sale notices or were repossessed by the bank.

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Nevada had the highest percentage of foreclosures with California, Arizona and Florida close behind. These markets were some of the hottest during the housing boom from 2000 to 2005.

“It’s definitely a different kind of market than what we got used to a couple years ago,” Devin Reiss, owner of Realty 500 Reiss Corp. in Las Vegas, told Bloomberg News. “We used to sell homes in a day. Now 50% of our sales are foreclosures.”

With a large supply of housing inventory already glutting the market, the influx from foreclosed homes is going to add to the housing markets woes.

Foreclosures will account for 30% of national home sales this year as 1.2 million foreclosed single-family homes will eventually enter the market, Michelle Meyer and Ethan Harris, economists at Lehman Brothers Holdings Inc. (LEH) in New York, wrote in a recent research report. They estimate foreclosed properties, which typically sell for about 20% less than other homes, will depress home prices nationally by 6%, Bloomberg reported.

Battered U.S. consumers are already struggling to deal with soaring gas and food prices. Losing the family home will tax already stretched incomes to the limits, delaying any possible recovery for the U.S. economy.

News and Related Story Links:

• RealtyTrak:
  Foreclosure Activity Increases 7 Percent In May

• Bloomberg News:
  Foreclosures Rise 48% in May as Repossessions Double

• Reuters:
  US May foreclosures rise 48 pct on year-RealtyTrac