How Americans Should React to the Fannie Mae Bailout

A little prediction I made last year is – unfortunately – coming true.

At an annual Alliance meeting in Playa del Carmen, Mexico, I predicted Fannie Mae and Freddie Mac, America's largest owners of mortgages, would go bankrupt. Months later, I urged readers of my investment advisory to "short sell" these two stocks. We're up 67% and 73% on our positions, respectively.

The gigantic problem with these quasi-government agencies has Washington D.C. working day and night on structuring a bailout. I'm certain the government will do whatever it takes to ensure Fannie and Freddie continue to operate – but that doesn't mean bailing out the shareholders. All the government will do is guarantee Fannie and Freddie's debts.

That means a huge amount of taxpayer money is about to go into troubled mortgages... A huge amount of money the government doesn't have and won't be able to increase taxes enough to afford. The government is going to pay for guns, butter, and housing.

I believe this means a big rise in the price of gold and silver... If you haven't positioned yourself against a severe dislocation in the U.S. mortgage system, you're making a big mistake.

Well, let me ask you, which do you think is more likely?

Scenario One: The U.S. government recognizes its financial mismanagement. It allows Fannie and Freddie to collapse and does not assume their liabilities. Mortgage investors take huge losses. Mortgage rates soar to more than 10%. Housing prices fall 75% – which makes housing affordable for millions of Americans previously priced out of the market.

In the meantime, the government cuts spending by 30% and reduces taxes radically to encourage economic growth (which, ironically, increases tax receipts, leading to a balanced budget). It restructures Social Security, moving the age of retirement to 75. And most importantly, the government gets out of health care completely, renouncing all of its Medicare obligations. Hospitals and doctors immediately drop their fees to compete in a free market.

Scenario Two: The U.S. government refuses to take responsibility for causing a bubble in mortgage finance. Rather than allow the bubble to deflate quickly, it bails out Fannie and Freddie. Mortgage losses build for five years, reaching more than $1 trillion. Housing prices stabilize in good neighborhoods, but risk-averse lending practices result in ghetto-like conditions and widespread vacancy across broad swaths of America.

Refusing to substantially raise taxes, annual deficits surpass $1 trillion in 2010. Total government debt begins to spiral out of control as our interest costs mount. Our foreign creditors lose confidence in the dollar and begin dumping it on the world market. Inflation surpasses 20% annually and prices for energy and precious metals soar.

I think Scenario Two is more likely.

No government in history has ever repaid debts as large as those already assumed by our government (in terms of GDP). Paying off these debts will put more pressure on the U.S. dollar. The single best way to protect yourself is to buy sliver.

When I explained this for the first time in May 2006, gold was trading for $675 an ounce and silver was trading around $14. Today gold is trading for $935 – an increase of 38% in about two years. Silver is now around $18, an increase of 28.5%.

These numbers tell me that, while you would have done well in precious metals over the last two years (far, far better than in stocks), the real move into gold and silver hasn't started yet. What should you do?

The answer seems obvious and urgent. Make sure you own a substantial amount of gold and silver. I would recommend at least a 5% position in gold and a 5% position in silver. I wouldn't allocate more than 15% of your portfolio. That should be plenty to hedge yourself. Don't forget, well-run companies will also appreciate along with other assets during an inflationary period. So you don't need to dump high-quality stocks and buy a huge position in gold and silver.

That's what I strongly recommend you do. Right now. Seriously. I wouldn't be surprised to see prices soar next week if Fannie and Freddie are taken over by the Feds, which is what I expect will happen.The best way to buy gold or silver, in my opinion, is to simply own bullion – plain coins. Buy them and bury them somewhere safe. The gold won't rust. Silver is more difficult to manage, but the best way to own it is to take physical possession. If you can't manage physical possession of the metals, consider ETFs or become skilled at analyzing mining stocks.

Good investing,

Porter Stansberry