Now we get to see what Paulson has in store for Fannie and Freddie

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Back in July, Treasury Secretary Hank Paulson asked Congress to trust him to deal with the troubles at Fannie Mae and Freddie Mac. He got his way, in the form of legislation that gave him more a less a blank check to bail out and reorganize the giant mortgage lenders. “The more flexibility I have, the more confidence that gives to the market, the less likelihood the authorities will be used and the better for the taxpayers,” he told TIME then.

Well, it turns out it didn’t give the market enough confidence to avoid a bailout altogether. Investors, who had bid the companies’ stocks up after Congress acted in July, soured on them again about a week ago. More ominously, there were signs that foreign central banks, until now big buyers of Fannie’s and Freddie’s bonds and mortgage-backed securities, were beginning to sell.

Between them the two companies–which don’t make loans directly to homebuyers but buy them from banks and mortgage firms–own or guarantee more than $5 trillion in mortgages. Right now they are about the only thing keeping mortgage markets in the U.S. going.

So something had to be done, and now word is out that Paulson is about to exercise his new authorities. Treasury is reportedly planning to put the two companies–created by Congress but owned by private shareholders–in government conservatorship. In the process, it is expected to throw out current management and invest taxpayer money in the companies.

How much will this end up costing taxpayers? At this point it’s still anyone’s guess–if house prices start rising again anytime soon, such a deal could actually make money for Treasury. If housing and financial markets continue to unravel, the cost could skyrocket past $1 trillion. Nobody really knows.

The big question for the moment is how this will play out for Fannie and Freddie shareholders. When the Federal Deposit Insurance Corp. takes over a failing bank, shareholders are usually wiped out, insured depositors are made whole, and everybody else (creditors, uninsured depositors, etc.) has to divide whatever money is left.

Holders of the mortgage-backed securities issued by Fannie and Freddie are pretty much equivalent to insured depositors. The MBSes aren’t officially insured or guaranteed by the government, but buyers have long assumed that they were. Even critics of the two firms agree that it would be disastrous if Treasury allowed the MBSes to default.

But what about the shareholders? It seems only fair that if the government has to step in to take over the companies, shareholders should lose everything. Except that there’s a big complication: Lots of small and mid-sized banks in the U.S. have, with encouragement from regulators, built up big holdings in Fannie and Freddie preferred stock, which they use to satisfy their capital requirements. If Fannie and Freddie preferred shares become worthless, a lot of banks will become insolvent. Which, with the FDIC insurance fund already being depleted by bank failure, could end up costing taxpayers a ton.

So Paulson has been trying to come up with a plan that reassures Fannie and Freddie MBS buyers, protects taxpayers, and at least partially protects the companies’ preferred shareholders. Is that even possible? We’ll see.

Update: New post on the topic here.