July 16 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson, who arrived in Washington two years ago from the summit of American capitalism, has been pummeled by the markets that nurtured him.

Investors are rebuffing Paulson's plan to rescue the nation's two largest mortgage-finance companies. Even with a recovery today, shares of Fannie Mae are down 9.7 percent since his July 13 pledge of government support, and Freddie Mac is down 12 percent. Yesterday the skepticism spread to his own Republican Party, signaling what may be a tough fight ahead for his proposal.

Paulson, who came from Goldman Sachs Group Inc. expecting his biggest tasks to be forging a compromise on Social Security and fostering an economic dialogue with China, today faces a deepening housing crisis and a stock market lower than the day he started.

``This is a man who finds himself in a whirlpool he never dreamed he'd see,'' said David Kotok, chairman and chief investment officer of Cumberland Advisors Inc., a Vineland, New Jersey, firm that manages $1 billion.

Stocks rallied today after profit at Wells Fargo & Co. topped analysts' forecasts, leading financial shares higher. Fannie rose 31 percent to $9.25 and Freddie was up 30 percent to $6.83, with the S&P financials index soaring 29 percent to 260.70.

Shifting Tack

Paulson is also advocating policies he might not have expected to embrace. His recognition that the threats Fannie Mae and Freddie Mac pose require a federal response helped convince President George W. Bush to back the rescue plan.

``In the short term, you do what you need to do to protect the financial system,'' Keith Hennessey, the director of Bush's National Economic Council, said in an interview.

The Bush administration's decision to back the mortgage companies, as well as the Federal Reserve's aid for Bear Stearns Cos. earlier this year, are ``specific cases that could involve systemic financial risk'' Hennessey said.

When Paulson, 62, started at Treasury in July 2006, consumer confidence in the U.S. was rising, stocks were advancing and crude oil cost half what it does today. His agenda included helping American businesses and workers become more competitive.

Debut Speech

``The global economy has been more robust than at any point I can recall,'' the former Goldman Sachs chairman said in his first major speech, in August 2006, at Columbia University's business school in New York.

That changed a year later. U.S. credit markets began to deteriorate in August 2007 as debt linked to mortgage-backed securities fell in value, altering Paulson's initial plans to address ``long-term challenges'' to economic growth.

As the crisis unfolded, sending stocks down for five straight months between November 2007 and March of this year, Paulson's initial efforts to respond met with only limited success.

He organized a group of mortgage lenders and services into an alliance called ``Hope Now'' to help struggling homeowners. It was criticized by House Financial Services Committee Chairman Barney Frank for moving too slowly.

Corralling Banks

Paulson tried to get banks including Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. to start an $80 billion fund to draw investors back into the market for short- term debt. Under an agreement he brokered, the fund would buy some of the $320 billion in assets held by structured-investment vehicles. The effort never got off the ground, because the banks decided to arrange their own rescues.

As the instability spread to Bear Stearns earlier this year, he helped organize the Fed's response: a $30 billion package to help facilitate JPMorgan's purchase of Bear in March. The government's help was needed to prevent the collapse of Wall Street's fifth-biggest bank from taking down the financial system, Paulson said.

``To be fair, he's facing problems that no one has ever faced before,'' said Peter Wallison, a fellow at the American Enterprise Institute in Washington and a former Treasury general counsel.

Those problems have multiplied with Fannie Mae and Freddie Mac. The companies have struggled as mortgage defaults soared, sending the value of mortgage-backed securities -- their main investment -- plummeting.

Paulson this week asked Congress to approve a plan to let the Treasury increase the companies' credit lines from $2.25 billion each, buy shares in them if necessary and give the Federal Reserve a role in setting their capital requirements.

Persuading Bush

He won the approval of Bush, who has ``tremendous confidence'' in Paulson, Hennessey said. ``There's no one with more experience, institutional knowledge and the connections to help the president.''

At the same time, Paulson's credibility has been called into question both by the market reaction to his efforts and at a hearing yesterday in the Senate.

``The market has reacted to your plan by driving down Fannie Mae shares 26 percent today,'' Senator Jim Bunning, a Kentucky Republican, told the Treasury chief. ``Freddie Mac's are down 29 percent at this moment, just in case you are interested in how the markets are reacting to your wonderful plan.''

Urgent Proposal

After a verbal lashing from senators of both parties, Paulson emphasized the urgency of the proposal.

This ``will be a great confidence-builder throughout the world, to see Republicans and Democrats, both houses come together and do something quickly here,'' he said.

Other lawmakers praise Paulson's willingness to work with Democrats. ``One of the things that Paulson has done is get the president to be sensible,'' Frank, a Massachusetts Democrat, said in an interview yesterday.

Paulson took the hearing in stride, David Nason, the Treasury's assistant secretary for financial institutions, said in an interview late yesterday. ``We're still optimistic that we're going to be able to get this done on a short time frame,'' Nason said.

Still, as Paulson spoke to the Senate panel, yields widened between Freddie Mac's and Fannie Mae's five-year debt and five- year U.S. Treasuries, signaling doubt that the government response would help.

Yield Premiums

The extra yield investors demand to buy Fannie Mae's five- year debt over Treasuries rose to 94.6 basis points today, compared with 81.8 basis points at the end of last week, according to Bloomberg data. Spreads on five-year Freddie Mac notes widened to 94.0 basis points, from 80.1 basis points in the same period. A basis point is 0.01 percentage point.

Paulson has repeatedly emphasized the virtues of ``market discipline'' -- code words for self-policing. Now, with Fannie Mae and Freddie Mac in crisis, he has endorsed what critics say may be an open-ended commitment to save them.

``They say there are no atheists in a foxhole,'' said Harvard economist Jeffrey Frankel, a former Clinton administration official. ``Well, there are no libertarians in a financial crisis, either.''

To contact the reporters on this story: Brendan Murray at brmurray@bloomberg.net; Rebecca Christie in Washington at Rchristie4@bloomberg.net

Last Updated: July 16, 2008 16:27 EDT