In normal times the second-largest U.S. bank failure in history would be the lead story in the mainstream media.

But we’re not living in normal times, says Dan Denning in The Daily Reckoning Australia. What we’re experiencing is a financial quagmire caused by the loud popping of an unprecedented credit bubble.

The collapse of IndyMac (IMB) has been overshadowed by the threat of insolvency at Fannie Mae (FNM) and Freddie Mac (FRE). The rescue plan for the twin mortgage giants is nothing more than backdoor nationalization, says Dan. Expect runaway inflation as a result of the government’s meddling…

First, let’s report what Paulson said, in case you missed it. Paulson denied last week any support for a shareholder bailout of the two companies. But it’s not the shareholders he’s worried about. It’s the bondholders. You can tell that from how Paulson began his statement.

He pointed out the importance of the GSEs to keeping the American housing market going. This, of course, is true. While non-bank lenders collapse and other banks tighten up, Congress expanded GSE lending powers earlier this year to keep the mortgage market from going into deep freeze. The result is that GSEs wrote 80% of the loans originated in the first half of this year. If they cease operating, the American mortgage market ceases to function. Imagine what that would do for house prices?

Scary as this, it is not even the biggest concern. Here is what Paulson said early in his statement: “GSE debt is held by financial institutions around the world. Its continued strength is important to maintaining confidence and stability in our financial system and our financial markets.”

There is some US$7 trillion in GSE debt sloshing around the world’s financial system. Non-American investors own about US$1.5 trillion of it. The Treasury Department desperately wants to assure investors that Fannie and Freddie will not default on that debt. But it does not want to explicitly “guarantee” the debt. Instead, it has taken three steps, with the Fed taking a fourth.

First, the Treasury Department will increase the line of credit the GSEs have with it. Currently, that line of credit is a pretty miniscule US$2.5 billion. If the financial markets know the Treasury is willing to loan billions more to the GSEs, it might calm things down a bit. Or not.

Second, the Treasury Department will ask the U.S. Congress for permission to purchase equity in the GSEs. You can be sure it will not be common stock, but some kind of preferred shares that give the Treasury and the U.S. Taxpayer some special benefits. Both this and the first measure are designed to be temporary and not last more than 18 months.

Third, the Treasury will ask the Congress to craft legislation that gives, “the Federal Reserve a consultative role in the new GSE regulator’s process for setting capital requirements and other prudential standards.”

The Federal Reserve’s Board of Governors also met this weekend and agreed to give the New York Fed “temporary authority” to lend to the GSE’s “should any such lending prove necessary.”

That’s the policy response crafted to comfort markets ahead of a week of trading. Now, shall we translate it for you?

The Treasury gives the GSEs a new line of credit. But will it matter? Freddie Mac is set to auction a relatively modest US$3 billion in bonds this week. It’s short-term debt, 3-6 months. If yields blow out at the auction, we’ll know the market is treating the GSEs like lepers.

And besides, the GSEs may have credit with the Treasury, but the real question now is how much longer the Treasury has credit with the rest of the world. Watch gold and oil. They will tell you exactly what the market thinks.

As for the equity stake, this is pretty intriguing. It’s going to be nearly impossible for the GSEs to raise capital in the private sector. And don’t count on a Sovereign Wealth Fund to save the day. These companies have massive liabilities. The U.S. government doesn’t want to explicitly guarantee GSE obligations, though.

Instead, what we see is a back-door capital raising through a rights issue. That is, the Feds hope that talking is enough to stabilise things. But if it doesn’t turn out that way, we see the GSEs taking on the Feds as preferred shareholders and then doing a rights issue, offering the American taxpayer a large stake in the companies in exchange for billions in capital to shore up the balance sheet.

Call it what you’d like, but it’s a backdoor nationalisation. If it’s done cleverly, the Feds hope it will prevent a run on the dollar and run away oil and gold prices. If it’s done clumsily, it will still result in run-away inflation without solving the solvency problem for the GSEs.

Source: Aussie Banks Lift Rates