Analysis: Hank Paulson, the US Treasury Secretary, has some tough decisions to make in the next few weeks on what measures he should take to support troubled Fannie Mae and Freddie Mac, America�s biggest mortgage finance companies.

Hank Paulson, the US Treasury Secretary, has some tough decisions to make in the next few weeks on what measures he should take to support troubled Fannie Mae and Freddie Mac, America's biggest mortgage finance companies.

Fannie - the Federal National Mortgage Association - and her brother Freddie - the Federal Home Loan Mortgage Corporation - are unusual institutions because they are quoted on the stock market but are backed by the US government.

Almost all US mortgage lenders, from huge Wall Street investment houses such as Citigroup to small, local banks, rely on Fannie and Freddie, tapping them for the funds they need to meet consumer demand for mortgages.

The two firms claim they make home ownership more affordable by lowering the interest rates on the 30-year mortgages they guarantee. They account for up to nine out of 10 secondary mortgages in America, and owe or guarantee about $5.3 trillion.

But the sub-prime mortgage crisis and the housing slump in America, that has left some parts of the country looking like ghost towns, has taken its toll on Fannie and Freddie. Their finances have been highly strained by rising defaults and falling house prices.

As mortgage guarantors, Fannie Mae and Freddie Mac must pay out when homeowners default on their loans. Their peculiar status has left them in a grey area between being government-owned and the private sector, with potential risks to the US taxpayer should they need bailing out.

The Treasury has gained the authority to rescue Freddie Mac and Fannie Mae, including buying shares in the two companies if needed, in a rescue plan approved at the end of July.

Paulson has said that it has no plans at present to bail out the two firms but economists believe he will eventually have to take action to make sure Fannie and Freddie survive because confidence in the two institutions has been badly shaken.

Wall Street institutions are looking to the Treasury to come up with a plan to prop them up because both agencies are woefully short of capital and in need of support. Whatever Paulson does to address this, there will be risks. His job is not an enviable one. The treasury secretary could take one of three steps to ensure Fannie and Fred are adequately capitalised and thus regain the confidence of US and overseas investors.

He could sit on his hands and leave the agencies alone, hoping that bond markets will continue to buy their debt. Rules and regulations can be changed to give Fannie and Freddie more breathing room. This may well be the preferred option for congressional politicians in an election year. Allowing the two institutions to fall into bankruptcy is not a serious option because it could cause chaos in the US and international financial systems and make the slump in the housing market longer and deeper.

A second option: Paulson could decide to inject fresh capital into the agencies, probably through preference shares, which have a priority over common stock. Analysts reckon that the Treasury would need to pour in $25bn to $30bn.

This would stabilise their situation, but losses will continue to mount, probably requiring additional cash.

An injection of about $30bn of new preference shares broadly matches existing issuance, much owned by small US insurance companies and regional banks which would suffer capital losses. The Federal Deposit Insurance Corporation would have difficulty in dealing deal with a raft of bank failures.

The FDIC warned last week that the number of troubled banks had risen by 30% during the second quarter of the year.

The third option: Paulson could decide to nationalise Fannie and Freddie. The initial cost to the US government would be a fairly modest amount because their market capitalisation is only about $6bn. One positive result would be lower mortgage rates. However, such actions mean the government takes a leading role in determining the future of the US housing market, a move that would likely be opposed by conservatives in Congress.

Trillions of dollars of Fannie and Freddie's debt would come on to the government's books, significantly adding to the existing public debt mountain.

Of the three options, nationalisation appears to be the best one. Andrew Milligan, head of global strategy at Standard Life Investments in Edinburgh, believes Paulson will take this step.

He said in a recent note to investors: "We must warn that US housing credit will be restricted until difficult decisions are eventually taken. Looking at the big picture, past financial crises, say in the US, Sweden or Japan, have ultimately required the government to take over much of the private sector's bad debts, opening the way eventually for a new expansionary phase in credit. The downside has commonly been an explosive effect on budget deficits and upward pressures on inflation. Some form of government nationalisation of Fannie and Freddie looks increasingly likely."

Shares in the two agencies, which have taken a beating on the New York market during recent months, climbed last week after Fannie Mae announced a shake-up of top executives.

Stephen Swad, who was chief financial officer since early 2007 and helped Fannie return to timely filing of financial statements following a major accounting scandal, was replaced by Fannie Mae controller David Hisey. Peter Niculescu, head of capital markets, replaced Robert Levin as chief business officer. Fannie Mae's chief risk officer, Enrico Dallavecchia, also left.

The changes "signal they are trying to correct some problems," said David Dreman, chairman of New Jersey-based Dreman Value Management, a Fannie Mae and Freddie Mac shareholder.

"When you change risk management people, it has to be viewed as recognising problems, so it is mildly positive."

In the coming weeks, the firms have more than $200bn of debt between them to roll over and the markets are uneasy. The collapse of just one bond auction could send shock waves around the world.

Freddie's next long-term debt sale, typically five-year notes, is scheduled for tomorrow. It also has a sale of one-month notes set for Wednesday, and of three- to six-month bills for September 22.

Fannie's calendar describes three to six-month bill sales as weekly but does not provide a date; it says one-year bills are sold monthly. Its next long-term debt sale of two to 10-year notes is scheduled for September 8.

Even if the auctions go well, the future of Fannie and Freddie is hanging like a dark cloud over Wall Street. Time is running out for Paulson.