Though Paulson liberally uses the word replace, he never states the preferred shares will not be carried into the new enterprises.

While Paulson clearly wants to wind down the GSEs’ profits and risks in maintaining large mortgage portfolios, he states that the government is profiting immensely from the spread between GSE backed MBS and treasuries. Unstated is the risk the government is incurring by borrowing short and lending long. Given enough leverage, the government could drive mortgage rates down to 4% and make a huge profit. This is Paulson dreaming because he then states that the amount of Treasury borrowing to accomplish this would be astronomical. I don’t know if Bernanke read the second part. But even if Bernanke did, he would not be afraid of large numbers.

I believe Fannie and Freddie will eventually become low profit utilities, guaranteeing less than 100% of the mortgage credit risk. Under either of Paulson’s recommended structures, the GSEs would pay the government for reinsurance. As utilities, the GSEs’ preferreds become more secure and therefore more valuable. Thank you, Secretary Paulson.

Final note: Paulson declared the GSEs failure would set off a systemically overwhelming disaster in the derivatives market. Since when is it the government’s job to prevent moral hazard from CDS counterparty risk? Likewise, government would not let American International Group’s (AIG) counterparties suffer.

Disclosure: Author is long ABK, AIG, FNM, FRE and MBI.