"Housing finance in the U.S. has long depended on the GSEs Fannie Mae and Freddie Mac," writes Stephanie H. Giroux, TD Ameritrade’s Chief Investment Strategist. "These mortgage lending giants were created by Congress in 1938 and 1970 to support the housing market, and currently hold $5.4 trillion of the roughly $12 trillion U.S. mortgage market. Over the past four quarters, Fannie and Freddie have posted losses totaling roughly $14 billion, as mortgage foreclosure rates continue to climb in the U.S.

The government’s intervention will result in the largest federal bailout in U.S. history, which is intended “to meet the objectives of market stability, mortgage availability and taxpayer protection," said Treasury Secretary Henry Paulson."

Just a quick reminder on the bailout plan: Freddie and Fannie will be allowed to increase the size of their portfolios over the next 15 months in an effort to improve mortgage affordability and stabilize the struggling U.S. housing market. "But beginning in 2010, in an effort to reduce overall systemic risk, the GSE’s mortgage portfolios will shrink by 10% per year," explains Giroux. Hang on. Isn’t that a massive contradiction?

A few of the skeptics, most notably a group of Morgan Stanley analysts, have pointed out that the Fannie and Freddie bailout plan seems to have two worthy but possibly conflicting objectives. First, the U.S. government aims to use the GSEs to repair the mortgage market. Second, the U.S. government aims to repair the mortgage market in a way that will pave the way to reform of the GSEs. Repair first, reform later – a $5.4 trillion contradiction.

By announcing plans to eventually scale down the portfolios of the GSEs, the U.S. government admits that the business model is flawed. Which then begs the question – how can the U.S. government use a broken business model to fix a broken housing market? How can the U.S. government expect foreigners to invest in the flawed business model of Fannie and Freddie? "Yet, that conflict may undermine global investors’ perception of officials’ resolve to fix markets, and thus investor and lender response to the plan is yet to be tested," concludes the group of Morgan Stanley analysts.

Disclaimer: I own SDS and DXD (short U.S. equities)