Bill Jamieson: The good, the bad and the ugly

IN THE most cathartic moment yet in the global credit crisis, stock markets soared yesterday on news of the world's greatest financial bail-out.

The move by the US government to take over the country's two mortgage giants, Fannie Mae and Freddie Mac, ends months of fevered speculation over their financial health. US treasury secretary Henry Paulson has pledged as much as $200 billion to help them cope with rising losses on mortgage defaults.

This is a huge gamble by the US administration. It may yet end in an a deeper crisis. It is made in the hope that it will cauterise the slump in the housing market and put the foundations in place for recovery.

On Wall Street last night, doubts already looked to be creeping in as earlier gains were pulled back. So what is likely to happen? Is this the end of the US housing and financial crisis? What are the risks the administration has taken on? Or might it prove yet another false start, with more severe and destructive consequences down the line?

Three scenarios lie ahead : The Good – which could be very good for those who feared the subprime mortgage debacle could bring a recession lasting for years; The Bad – more prolonged uncertainty, anxiety and weak economic performance; and The Ugly – a run on the dollar as international investors take fright at the scale of the liabilities now being taken on.

The weekend's dramatic intervention – the culmination of weeks of top secret meetings that began with the gathering of executives of the US Federal Reserve at Jackson Hole, Wyoming , in early August – saddles US taxpayers with billions of dollars of potential mortgage losses.

The scale of this intervention is colossal. Together, Freddie and Fannie account for almost half of America's $12 trillion (£6.8 trillion) outstanding mortgages. And arrears and defaults are climbing. Currently, about 9per cent of US mortgage holders are behind in their payments or face repossession.

And think, too, of the magnetite of the "'toxic assets" – sub-prime related derivatives – that have brought near seizure to the financial system. Around $500bn of subprime tainted paper has already come to light.

But there's an estimated $500bn still lurking in the banks' books. This is what has brought on the crisis in world markets and explains why banks have been scared to lend to each other, intensifying the credit squeeze.

The move by the administration to take control of the two agencies is pre-emptive. The cost of standing aside and letting both go to the wall with a resulting financial panic was deemed far greater than the action announced on Sunday.

In Paulson's words: "Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil, here at home and around the globe." His action removes that risk.

However, the government has taken on a huge potential liability – and it may well open the way for further intervention. The Wall Street Journal speculated yesterday that the next big intervention will be the creaking credit card industry and also in support for the US auto industry which has taken a battering as sales have slumped.

Moreover, this is the third time this year that the credit crisis has forced the US authorities to make major policy announcements over a weekend. And the track record is not good.

The first occasion was in March when the Fed provided emergency support to investment banks. There was a global relief rally – but the gains were lost after two months.

The second was in July when the administration signalled it would stand behind Freddie Mac and Fannie Mae ("Paulson's pistol in his pocket"). The rally lasted barely a month.

This time the government, the Federal Reserve and Wall Street will be desperately hoping that yesterday's rally does not fizzle out as the previous two have done. There are no more shots in the locker.

So what might the three scenarios offer?

THE GOOD

Nerves are steadied in credit markets while home buyers have more confidence that, with the government directly involved in mortgage provision, the worst of the housing crisis may soon be in sight. Capital is attracted from both domestic institutions and foreign sources such as sovereign wealth funds. Private institutions may be more willing to resume purchases of mortgage-backed securities. Interest rate spreads fall and the great credit freeze begins to thaw. The administration can then wind down the activities of Freddie and Fannie and sell them back to the private sector.

THE BAD

The relief rally peters out as the economic slowdown continues. Unemployment rises further and the new post-election administration launches a reflationary economic package to help the economy. But that means yet more government debt – and a deeper inflation problem ahead. Progress to recovery is slow and faltering.

THE UGLY

Least likely, but should not be ruled out. Doubts quickly set in about the soundness of the dollar. Overseas investors worry about the billowing growth in US government debt and the creditworthiness of US treasury bills. Foreign banks and institutions pull out billions of dollars invested in US mortgage securities that are guaranteed by Fannie and Freddie. A deepening slowdown, rising unemployment, rising arrears and repossessions trigger a panic flight from the dollar. What would then unfold is a financial crisis and full-blown Depression that would make the past year seem like a picnic.