Fannie, Freddie: Feds Step In

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In fact, that's how conservatorship was described by James Lockhart, director of their regulator, the Federal Housing Finance Agency, who joined Paulson at the Sunday press conference.

Under the government's conservatorship, Fannie will be run by Herb Allison, a former CEO of Merrill Lynch (MER) who most recently ran TIAA-CREF , the big teachers' pension and retirement fund. Freddie will be run by David Moffett, former vice-chairman of US Bancorp (USB).

Not Business as Usual

In reality, it is almost inconceivable that Fannie and Freddie will get back to business as usual. Paulson made it clear he thinks the companies were structured incorrectly from the start and had an inherent conflict of interest between their duties to shareholders and their obligations to support homeownership. Because of Fannie and Freddie's public obligations as well as their enormous size, investors in the U.S. and around the world correctly surmised that the federal government would never let them fail. In the future, Paulson said, "government support needs to be either explicit or nonexistent."

Paulson also set a deadline for reform, which comes after the Bush team is out of office. He said that under the timeline he envisions, Fannie and Freddie will expand their operations to support the hobbled housing market by buying or insuring more and more mortgages between now and the end of 2009. Starting in 2010, though, Paulson said the two companies should begin shrinking their portfolios at a rate of 10% a year.

December 2009 is also the planned expiration date for a new secured lending facility that's available to Fannie, Freddie, and the 12 federal home loan banks. (Secured loans are ones in which the borrower must post collateral, such as mortgage-backed securities.)

Taxpayers at Risk

It's impossible to say how much the effective takeover of Fannie and Freddie will cost taxpayers. If housing prices begin to recover and foreclosure rates don't get too high, the cost to the government could be very small or zero, because Treasury will earn a return on its preferred shares and get all its secured loans repaid.

Still, the deal is likely to draw criticism because it puts taxpayers at risk while boosting the value of Fannie and Freddie's bonds and mortgage-backed securities, which are held by banks and other investors around the world. Asian central banks, in particular, are large holders.

One group that won't be getting any kind of a bailout: Fannie and Freddie's ordinary common shareholders. They stand last in line for any money the two companies make. Share prices of both Fannie and Freddie have lost more than 90% of their value over the past year, in anticipation of a takeover. In after-market trading on Sept. 5, as word of the conservatorship plans leaked out, Fannie shares were trading around $5.50, down from $70 a year ago, while Freddie Shares were at about $4, down from $65 a year ago.

Candidates Weigh In

Senator Barack Obama, the Democratic Presidential candidate, released a statement on Sept. 7 saying, "Given the substantial role that Fannie Mae and Freddie Mac play in our housing system, I believe that some form of intervention is necessary to prevent a larger and deeper crisis throughout our entire economy." He said he wasn't yet ready to say whether Treasury's solution was the right one.

The Associated Press reported that Senator John McCain, the Republican nominee, said at a rally in Albuquerque: "We need to keep people in their homes, but we can't allow this to turn into a bailout of Wall Street speculators." Doug Holtz-Eakin, McCain's top economic adviser, said that longer term, "We believe these institutions should not be making money" through government support. "They have to shrink to a point where they are not a threat, that they are not operating essentially as a big hedge fund."

Peter Coy is BusinessWeek's economics editor; Theo Francis is a writer in the Washington bureau .