The government has come to the rescue!

U.S. Treasury Secretary Hank Paulson has announced an emergency response plan to prevent troubled government-chartered mortgage firms Fannie Mae (FNM) and Freddie Mac (FRE) from facing a major liquidity crunch.

But what does it all mean for investors? That depends on your point of view. The further decline of the dollar, more banking failures as the fed’s money supply tightens, more burden on American taxpayers. Take your pick…

Currency expert Chuck Butler says Fannie and Freddie are putting more downward pressure on the dollar…

Paulson has thrown the Treasury behind Freddie and Fannie. I guess that’s better than taking them over, which is what I thought he was going to announce on Friday morning.

So… The Perfect Storm was averted, but still the negativity toward the dollar came front and center most of the day, with the euro (EUR) rallying to 1.5935.

Overnight, we’ve seen some short covering in the dollar, causing the euro to fall back to 1.5860… But, that move on Friday is just a tiny taste of what could happen to the dollar, should these “risk events” continue, as I believe they will!

Bill Bonner says there is no way the Federal government can cover Fannie and Freddie’s $5 trillion liabilities. They may be ‘too big to fail’ but finding the cash to support these two behemoths is not going to be easy…

Here at The Daily Reckoning we know how they got themselves into such a jamb. They lent money to people who couldn’t pay it back. And they weren’t the only ones.

“Crisis Deepens as Big Bank Fails,” adds the Wall Street Journal. The big bank is IndyMac (IMB). It is the largest bank failure since Continental Illinois bit the dust in ‘84. Much of the depositors’ money is protected by FDIC insurance. But there’s still $1 billion uninsured. And, of course, FDIC can’t bail out everyone; it only has so much money.

“Analysts say more banks could fail,” reports the International Herald Tribune.

FDIC can bail out a few of these banks…but not all of them. And there is no way it can bail out Fannie and Freddie. Together, the twins have more than $5 trillion in liabilities. That’s more than a third of US GDP. And former Fed governor William Poole says they’re broke already.

Investors are still holding on – barely. Fannie’s shares fell to $10.25 on Friday. Freddie was down to $7.75 – for a total loss of 87% from the peak.

Fannie and Freddie are “too big to fail,” no doubt about it. But who has the money to stop them from failing? Where are those Sovereign Wealth Funds when you really need them? We doubt whether they are stupid enough to do it, but what a coup it would be! We mean, if the Sovereign Wealth Funds recapitalized America’s largest mortgage lenders.

So far, they’ve contented themselves with a few minor purchases of America’s iconic buildings, infrastructure and industries. But if they bought control of Fannie and Freddie, they would hold the mortgage on America’s housing too. And they could get rid of trillions of their unwanted dollars. (Foreign central banks already hold large pieces of Fannie and Freddie’s debt.)

But for the moment, the bailout looks like it will come from homegrown sources. Ben Bernanke called on Freddie’s CEO over the weekend. It is believed that the Fed chairman let it be known that its discount window would be opened a bit wider today – wide enough to lend directly to Fannie and Freddie. This will give them access to money at a preferential rate – about half the rate of consumer price inflation. You’d think you could make a fortune – if you could borrow so cheaply. In “normal” times, it would be a cinch. But in wartime, it’s hard to make money – even when lenders give you credit at no cost. No matter where you put the cash, it’s always in danger of getting blown up.

According to Justice Litle in Taipan Daily, taxpayers are going to pay dearly for the conniving of politicians and Wall Street to finance the American Dream…

So how did we get into this mess? “Stupidity” is one word that immediately springs to mind. Others are greed, foolishness, myopia, idiocy, and so on. You get the picture. The sheer larceny of it all speaks volumes as to why you should own gold.

The thing to understand about Fannie and Freddie is that their special deal wound up being the worst of both worlds.

The gray area both resided in — not exactly public institution, not exactly private enterprise — has produced the ultimate in bad results for taxpayers (you and me), while lining the pockets of countless politicians and insiders on the road to fiscal ruin (the place we’ve just arrived).

To better understand, let’s take a look at Fannie Mae, the Federal National Mortgage Association (as little brother Freddie basically followed in big sister’s footsteps).

Here is the bottom line: As a “quasi-government entity,” Fannie was always seen as “too big to fail.” What’s more, Fannie enjoyed implicit backing from the U.S. government… the very strong hint, though, not the spelled-out promise, that its finances were guaranteed by Uncle Sam.

This quasi-public status and implied guarantee helped Fan sell massive amounts of debt at super low interest rates.

The thing is, Fannie was also a private company with stockholders, a share price and a profit-driven culture. This created an intense pressure to drive profits higher. Everyone from Fannie Mae execs to big shareholders wanted to see rising earnings, a rising stock price, and so on.

A Hedge Fund in Drag

In the mid-1980s, Fannie Mae almost went under thanks to horrible management of its loan book. Then a new (and much smarter) team stepped in and brainstormed on how to get profits up.

The new managers quickly realized what a huge asset they had in terms of the public/private straddle. This unique deal let Fannie borrow huge sums from investors at piddling interesting rates. The rock-bottom borrowing costs meant they only needed a few percentage points of return to make a lot of money.

Here’s how it works: If you have a super-safe strategy that earns you, say, just 0.5% a year, you can still get very rich. All you have to do is borrow huge sums to magnify the return.

If you can borrow, say, 40 times your original capital and plow it all into your 0.5% strategy, then all of a sudden you’re making 20% a year (0.5 at 40x leverage = 20% return).

This is pretty much what Fannie Mae figured out… that they could borrow insane amounts of money thanks to their public status, plow the borrowed funds back into mortgages for a slightly higher rate of return, and basically operate as a hedge fund in drag.

Cui Bono Redux

On Friday we introduced the term “cui bono?” which is Latin for “who benefits?” With the Fannie and Freddie story, cui bono applies in spades.

After Fannie figured out the public/private “hedge fund in drag” strategy — and Freddie copycatted it — the sky became the limit in terms of profits. Fannie’s share price had risen many thousands of percent from its 1980s low, and that was just the start.

In fact, the only real limit on profits, it seemed, was a lack of mortgage loans to buy. Fannie was getting so big, there was a danger of buying up too much of the nation’s mortgage pool. It might look bad in the eyes of the public for a quasi-public entity to start shoving its private competition aside.

So what did Fannie do?

They figured out how to make the mortgage pool bigger… much, much bigger… by chipping away at the “20% down” feature that traditionally kept riskier buyers out of the mortgage market.

Basically, Fannie started a series of political campaigns aimed at improving the plight of the poor would-be home owner who couldn’t afford 20% down on a house.

Home ownership was as American as mom and apple pie, the campaign argued, and who are we to stand in the way of the American dream just because John and Jane Public can’t scrounge up a hefty 20% down.

The strategy worked like gangbusters; down payments fell, and everyone was happy. Politicians loved it, because more of their voters could own homes. First-time home buyers loved it, because 5% down (or even 0% down) made it so much easier to buy the house of their dreams. Wall Street loved it, too, for obvious reasons.

But Fannie and Freddie execs loved it most of all, because the more the mortgage market expanded, the higher their profits soared into the stratosphere.

As the mortgage market grew by trillions, Fannie’s and Freddie’s mortgage books grew by the trillions, too. Their leverage strategy made Long-Term Capital Management look like pikers. Eventually their eyes got bigger than their stomachs, the market turned with a vengeance, and now here we are staring down the barrel of a housing crisis.

It was pure greed, plain and simple. And we all bought it…

No Free Lunch

There is no free lunch on Wall Street. (Some say that diversification counts as the one free lunch, but that’s baloney, too. You can’t get rich avoiding concentration.)

Now we are realizing, the hard way, that there is no free lunch when it comes to the American Dream, either. The dream of homeownership has become a nightmare for millions of Americans.

Just remember this: When politicians and executives and investment bankers get together to do something for the greater good, you can be sure that the first and last “good” that will be served is the good of their wallets.

And that’s why you need to own gold… because this debacle is far from done. In fact, it’s just getting started.

With the Bear Stearns failure, the IndyMac Bank failure, and now the as-yet-to-be-determined Fannie and Freddie rescue, we are paying for the ill-gotten gains of many years prior.

The motto of the players might well have been, “Reap billions now; let others foot the bill later.” Later being right now and the bill-footers being taxpayers… you and me.

If the cost is not paid via the IRS, then it will be paid via rampant inflation, as the printing press slowly turns the dollar into monopoly money.