Investors figured out today that the Paulson/Bernanke rescue plan is not going to save Fannie and Freddie in their current form as private companies. The stock of the two companies dropped—5% for Fannie and 8% for Freddie—while Freddie had a stronger than expected demand for its debt offering.

This is exactly what we would expect. The two companies are now on the inevitable road to being bailed out, nationalized, and shrunk—not as bad as being drawn and quartered, but not good either.

Why do I say inevitable? We now have a situation where the Treasury Secretary and the Fed Chairman have taken the first small steps towards placing the full faith and credit of the U.S. government behind two private financial companies. These steps cannot be undone. Once the promise has been made to investors—however vague—the government has to step up to fulfill it.

The logical end state here is a full takeover. It’s simply not sustainable for two private companies to be able to do business as usual with a full and explicit government guarantee. It’s not fair to other companies, and it opens up the door for all sorts of risk-taking which could make the problem even worse.

However, the markets have correctly assessed that Paulson/Bernanke are committing to making the debtholders whole, but they are making no such promises about the shareholders. In fact, good central banking practice says that the shareholders should take a very deep haircut if there’s a bailout/takeover, just like what happened with Bear Stearns.

My timeline for the full transition, as per my earlier post, is still the beginning of the next administration. I think the next president, whether it’s Obama or McCain, will be looking at a $400-$500 billion bailout of the U.S. housing sector. This will encompass not just Fannie and Freddie, but a wide buy-up of bad mortgages—just getting them off the books of the financial sector at a substantial discount.

It’s worth looking at the S&L crisis of the 1980s to see how that might work. The total size of the bailout back then was $225 billion (see the GAO report, Appendix I, page 31). The Resolution Trust Corp recovered $140 billion, so taxpayers had to put in roughly $85 billion (these numbers are very rough).

Assuming that the same ratio holds this time, a $400-$500 billion bailout would end up requiring $150-$180 billion of taxpayer money, spread out over several years.

That’s a lot of money—which is why I don’t think anything major can be done with the presidential election looming, though Paulson went further than I thought he would.

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