In case you didn’t hear, the government finally jumped into the mortgage business over the weekend when the politicians officially nationalized Fannie and Freddie.

Without an official guarantee from Washington, the odds of a full-scale mortgage-backed crash was imminent. So you could argue Paulson’s pre-emptive strike on Sunday was successful.

Spreads, or the difference between risk-free Treasury bonds and mortgage-backed debt, remained elevated all year until this past Monday. That rate was 2.74% last Friday or 6.40% - the highest spread versus T-bonds since the credit crisis began.

Meanwhile, the 30-year fixed rate mortgage plunged from over 6.40% on Friday to 6.04% on Monday. In other words, the bailout alleviated credit stress on that segment of the mortgage market. That’s the good news.

The bad news is that “jumbo” mortgage rates, or mortgages considered too large to be purchased by Fannie and Freddie climbed to 7.35% from 7.14%. How the jumbo market will react going forward is anyone’s guess. But the primary concern for the market is that lending giants Fannie and Freddie remain solvent and recapitalized by the federal government.

Paulson, a former Goldman Sachs chief, is no stranger to structuring deals. In some ways, the United States and its foreign creditors are lucky because anyone else holding this position would have no idea how to put together such a complex rescue package.

Here’s the plan: The Treasury will recapitalize the government-sponsored enterprises (GSEs) by gradually buying preferred stock. Of course, stock holders will get the short end of that stick. Fannie and Freddie shares collapsed about 85% on Monday.

I’ve already purchased intermediate and short-term Fannie and Freddie debt. Spreads should continue to narrow over the next several weeks as investors return to this market. These bonds, along with high quality corporate bonds are among the best values today in fixed-income markets. In stark contrast, treasury bonds offer you poor values adjusted for inflation. They’re also overbought.

Taxpayers, naturally, will fund this enormous bailout. The Savings & Loans crisis in the late 1980s cost taxpayers about US$300 billion adjusted for inflation since 1989. This bailout should easily match those figures. It might ultimately be twice that amount if housing values don’t stop falling soon.

Freddie and Fannie May Be Debt-Ridden,
But Their Bonds Are Worth Holding

Central banks are notorious for their ill-timed investments. The latest such trade was conducted by several Chinese banks in August as they reduced their combined positions in Fannie Mae and Freddie Mac debt.

Erring on the side of caution, you can’t blame China’s banks for selling Fannie and Freddie debt. After all, many of these banks have already lost billions betting on global stocks recently, including U.S. banks.

But the timing of the sale is just dead-wrong. Right now, both lenders have the implicit U.S. government guarantee that Freddie and Fannie won’t fail. Plus, Freddie and Fannie have some of the richest spreads versus Treasury bonds in history. Fannie and Freddie bonds have gained 3% in 2008.

If anything, now is the time to buy, not sell, Fannie and Freddie debt. PIMCO is probably the savviest bond investor in the world with more than US$800 billion in assets. Recently, PIMCO has been aggressively accumulating mortgage-backed securities.

Last week, PIMCO announced they may be creating a private fund to buy the highest quality mortgage-backed securities.

China’s recent paring of U.S. GSE (Government Sponsored Enterprises) holdings is not significant considering all positions are valued at less than US$13 billion.

Both mortgage lenders have issued hundreds of billions of dollars in fixed-income securities over the years. China’s slicing of US$23.3 billion on December 31 to US$12.7 billion as of August 25 won’t affect GSE pricing in a big way. The figure is not big enough.

Global central banks - including several Asian and Middle Eastern banks - have a bad track record making investments lately.

Sovereign Wealth Funds, or SWFs, have been aggressively buying distressed U.S. and European financial services companies since the sub-prime market exploded in August 2007. These guys have already lost billions on paper since last fall.

Central banks are also notorious for making the worst investment decisions at the wrong time. Over the last decade a host of central banks have dumped gold just as prices bottomed in the late 1990s.

Are Chinese banks right to reduce GSE holdings this summer? My guess is probably not. I’ll bet on PIMCO.

Every other month, it seems, global markets are teetering on the brink of panic. Then central banks step in to calm investors. They inject the credit markets with more money while investors scramble to reposition their portfolios.

It’s been nearly an impossible environment to make money in recently too. Volatility is intense and every asset class is now heading into the basement since commodities peaked in early July. Only U.S. stocks are showing gains since July 15.

Over the last 12 months we’ve seen four global panics triggered by solvency concerns revolving around Bear Stearns Cos., Northern Rock plc, Lehman Brothers, Countrywide Credit, General Motors and, since July, Fannie Mae and Freddie Mac.

On Tuesday, former IMF chief economist, Ken Rogoff, declared a big financial institution will collapse before the credit crisis draws to a conclusion.

This never-ending saga of financial crises has morphed into a monster. And, like a bad dream, it just doesn’t go away.

The latest debacle shaking global markets upside down are mortgage giants Fannie and Freddie. Combined, they guarantee more than US$5 trillion worth of U.S. mortgages. Without them, there probably wouldn’t be much of a mortgage market.

Until the housing market finally establishes a bottom, Fannie and Freddie are going to remain under pressure. Balance sheets at both companies continue to hemorrhage while home values plunge and both mortgage and refinance application numbers tank. Home prices are now down 10% year-over-year and mortgage and refinance applications are down a heavy 37% and 44%, respectively. Those figures are outright bearish and suggest investors have run out of patience with Fannie and Freddie.

Instead of playing political football and jockeying around the bailout issue, the Treasury and Congress should just bailout Fannie Mae and Freddie Mac. It’s inevitable anyway. I think the Feds are waiting for the housing market to bottom before officially entering the mortgage business. No dice.

We already know Secretary Treasury Paulson has given the markets an implicit guarantee that the federal government won’t allow these giants to fail.

So if that’s the case, just bail them out already! Shareholders will get wiped-out in the process and the United States will officially be in the mortgage business.

Credit markets remain on edge. Stocks worldwide are plunging, non-government bond markets are reeling and most commodities remain in a vicious downtrend since hitting multi-decade highs in July.

Deflation, not inflation, is now the markets’ primary focus. Housing woes are adding pressure to deflationary trends in the United States and now, Europe. Again, the main threat since July to global markets is deflation.

The federal government will bailout Fannie Mae and Freddie Mac with taxpayers naturally footing most, if not all, of the bill. If the Feds don’t orchestrate a bailout soon, there’s a good chance markets will crash and government bond yields will plunge. It’s that serious.