Government Leap Into Fannie, Freddie 'Sinkhole' Buys Time for Financial System

By bringing the hammer down on Fannie Mae and Freddie Mac shareholders, Treasury Secretary Hank Paulson appears to have built a floor under the financial markets, at least judging by the initial reaction.

Major elements of the plan, announced Sunday afternoon, include:

• Fannie and Freddie being placed under conservatorship administered by the Federal Housing Finance Agency, which was created by this summer's Housing Bill.
• Treasury has pledged to buy as much as $100 billion each of newly created senior preferred shares of Fannie Mae and Freddie Mac.
• Treasury will be issued $1 billion in senior preferred stock of both Fannie and Freddie, which will pay 10% annual dividends.
• Treasury will receive warrants to buy as much as 79.9% of the equity in each firm.

There's a lot of talk about what the plan does or doesn't mean for the housing market and how the new senior preferred shares effectively wipe out the value of existing preferred and common shares.

But "all that matters" is $5 to $6 trillion of mortgage-backed securities backed by Fannie Mae and Freddie Mac "won't hit the market," says Scott Bleier, founder of CreateCapital.com.

By pledging to buy mortgage-backed securities guaranteed by Fannie and Freddie, the Treasury has taken that risk off the table, Bleier says.

Whether the U.S. government can actually turn a profit on this transaction, as Treasury claims is the plan, remains to be seen; Bleier says it's a "sinkhole" for the first five years. But he noted the government can hold bad debt for a lot longer than private entities like, says, Pimco, which appears to be the primary beneficiary of this deal, and perhaps its catalyst after Bill Gross' warning of a "financial tsunami" last week.