A desperate but necessary bailout

It can, so long as it enjoys a bit of luck and isn't blocked by impatient stakeholders both at home and overseas. But it has a tough bar to clear for success: It not only must keep U.S. home prices from deteriorating further, but also must break the logjam of commercial and consumer credit and kick-start stalled domestic economic growth. The stakes, and expectations, may be impossibly high.

Though the plan allows the companies to avoid bankruptcy, it's uncomfortably close to what Japan tried in the 1990s to keep many of its faltering banks afloat in the tragic aftermath of its own lending bubble. That practice, intended to prevent stakeholders from losing face, created "zombie" entities that bled the country dry for the next decade. The drain stemmed from the government floating billions of dollars' worth of new bonds to create the money to shore up the companies' capital bases, and that crowded out investment dollars that could have gone into more-productive activities, such as starting businesses or expanding factories.

The plan for Freddie and Fannie bypasses the Fed by creating a "conservatorship" for the two organizations that own more than half of U.S. home mortgages. This is like the receivership of a forced bankruptcy -- in which court-appointed experts run a business in place of disgraced former management and untangle all the screw-ups -- but it's a touch more genteel.

Technically, the Treasury plan changes the capital structure of the organizations by guaranteeing their $5 trillion in senior debt and inserting a new class of high-yielding secured debt between equity and that senior debt. The plan slightly expands the ability of the two banks to increase their mortgage-backed-security businesses now, though it requires them to shrink their portfolios of business dramatically after 2010 to a maximum of $250 billion from the current maximum of $850 billion.

This idea produced a big sigh of relief to all the Asian and European fund managers who own the senior debt even though, at the same time, it basically wiped out the equity shareholders -- mostly mom-and-pop retail investors here at home. The shares will remain listed on the New York Stock Exchange for reasons that only legal scholars and penny-stock scammers can understand, as the Treasury apparently wishes to maintain the fiction that they will be worth something one day.

Both stocks will be removed from the Standard & Poor's 500 Index ($INX) at the close of business Wednesday. Freddie Mac will be replaced by business software company Salesforce.com (CRM, news, msgs). Replacing Fannie Mae: industrial supplies maker Fastenal (FAST, news, msgs).

The best-case result

If the Treasury plan works like a dream instead of this nightmare, foreign debt holders will be so excited to buy newly guaranteed Fannie and Freddie debt that they will compete like crazy to buy it -- driving down the yield that must be paid as enticement. That could have the effect of cutting U.S. home mortgage rates by as much as a full percentage point.

Combine lower rates with lower gasoline prices, higher consumer confidence and falling home prices and you can visualize an incredible resurgence in buying, which would slash the vast inventory of unsold homes that's impairing the residential construction industry and get homebuilders revved up again.

Analysts at ISI Group in New York did some math and figured that if you take July's median home price at $204,000, pay 20% down and get a 30-year mortgage at 6.4% interest, the after-tax monthly payment is $795, which is 20.7% of the average American's after-tax income -- a very low level, historically. The National Association of Realtors' housing affordability index is showing the same thing: It's already a good time to buy a house due to price deflation, and if the Treasury's weekend intervention chops mortgage rates, we could be on the verge of a real upside surprise for the economy and the market.

The catch? Well, unfortunately, this plan would have worked a lot better a year ago than now because what started out as a mortgage crisis back then has since metastasized into a broader debt crisis. The litany of woes and negative feedback loops is familiar by now, but just for old times' sake I'll note that falling house prices led to foreclosures among overleveraged homeowners, which in turn led to massive losses at overleveraged banks, which in turn have withheld credit from businesses, which in turn has led to reduced production, which in turn has led to the biggest increase in layoffs in two decades, which in turn has put big smokin' holes in consumers' balance sheets and which has led, finally, to widespread problems with credit card loans, car loans and student loans.

As a result, even though a lot of families would love to obtain a mortgage at the lower rates made possible by the new Treasury deal, a rising number of breadwinners are simply disqualified from buying houses because they're out of work or afraid of losing work, or their credit scores are too messed up to qualify for loans.

Now you know why I called the plan a Hail Mary. Start praying.

At the time of publication, Jon Markman did not own or control shares of any company mentioned in this column.

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