The most powerful man in Washington, Treasury Secretary Hank Paulson has shown himself to be quite a shrewd politician. The prevailing wisdom is that he accepted the $300B FHA housing bill so that he could create the Fannie Mae (FNM), Freddie Mac (FRE) and Federal Home Loan Bank (FHLB) backstop. The much talked about unlimited power of the Treasury to lend and buy equity, which will never be needed. I disagree. I believe that Paulson created the heightened GSE anxiety for the express purpose of passing the Frank-Dodd FHA mortgage refinancing bill.

Paulson’s high-wire balancing act involved appeasing the Administration’s need for moral hazard by feeding the Republicans Bear Stearns (JPM), and then feeding the Democrats the GSE backstop to tack onto their FHA bill. A setup that made the FHA bill veto proof. President Bush showed his distain by signing the bill privately. From Paulson’s and Bernanke’s perspective it is the FHA component that will provide the most benefit to the banking system. Paulson’s pragmatism triumphed in a tough political environment.

This giant combo bill brings difficulty to PIMCO’s Bill Gross and Pershing Square’s William Ackman. Both are betting that the GSEs will be nationalized by the Treasury and have used the backstop to plead their case. Nationalization would benefit Gross by increasing the value of GSE notes and bonds, and Ackman by making the shares he is shorting worthless. Both are pressuring the Treasury to buy GSE equity in the name of expanding GSE support for the mortgage market.

Gross has engaged Alan Greenspan to plead his case in public. Several Wall Street analysts are also preaching the dire consequences of a reduced GSE role in the mortgage market. They cry that without a Treasury takeover, no one is out there to pick up the reduced GSE demand for mortgages. Therefore, it is unconscionable for the GSEs to strengthen their balance sheets by reducing their portfolios.

Too bad for Gross and Ackman, Paulson has another point of view. Fannie and Freddie can reduce their portfolios and the FHA will pick up the slack. What Gross and Ackman lost sight of is that many banks own GSE equity (mostly preferred) and the failure of GSE equity would reduce banks’ capital adequacy. Paulson and Bernanke don’t want that to happen.

Disclosure: Author is long FNM, FRE and JPM.