If anything is clear as the housing and mortgage debacle stumbles seemingly ever-forward, it’s that the government’s response to the crisis has proven the theory that some institutions really are too big to fail; the orchestrated take-over of Bear Stearns & Cos. in March, which left the Federal Reserve holding the bag on roughly $30 billion in the Wall Street firm’s hardest-to-value assets, may have set the precedent, but it surely hasn’t ended there. Instead, the endgame for the “too big to fail” issue that has bedeviled market participants throughout the ongoing credit mess may come in the form of dual housing giants Fannie Mae (FNM) and Freddie Mac (FRE), who on Wednesday appear set to gain approval from Congress for a historic lifeline to the U.S. Treasury. Under the plan, the government would expand its credit line to the two mortgage industry giants, while gaining the authority to make unspecified equity investments into one or both government-sponsored enterprises. In remarks Tuesday, Treasury secretary Henry Paulson suggested that part of the long-term solution to current market turmoil is to find a way to get past the idea that some institutions are simply too large to fail. It’s an ethic clearly rooted in someone who cut his teeth on Wall Street. “Looking beyond today’s market challenges, we need to get to the point where large, complex financial institutions are not perceived to be too big or too interconnected to fail,” he said in a press conference in New York. Good luck. With the Securities and Exchange stepping in late last week and providing short-sale protections to certain financial securities (and, notably, not to others), it’s clear that the idea of “too big to fail” is more embedded into our financial markets than ever, complex mazes of credit default swaps notwithstanding. And beating that sort of logic out of a market’s collective psyche, and out of the minds of regulators as well, is likely to prove a tall order at this point. Not that Paulson has been daunted by the challenge. Winding our way out of this mess, he reiterated Tuesday, will ultimately require putting infrastructure in place that allows institutions — particularly non-bank financial firms — to fail without threatening the financial fabric; the SEC chief has been pushing as of late for an FDIC-like receivership program that would allow the government to step in where needed, with the idea that such authority might help avoid some of the market panic that we’ve seen on and off since February of this year. “Improved infrastructure will add to market stability and mitigate the likelihood that a failing institution can spur a systemic event,” he said. “We also need additional powers to manage the resolution, or wind-down, of large non-depository financial institutions, such as larger hedge funds, so as to limit the impact of a failure on the broader financial system.” The exception to the rule But there are always those firms that refuse to fall in line with a well-laid strategy; and in Paulson’s case, the twin GSEs have been a particularly difficult albatross to address — especially so given his own personal misgivings towards the firm’s dual missions of protecting shareholder returns while providing liquidity to the nation’s mortgage market. “My views on their structure are well known – they are an odd construct, with a difficult dual mandate to serve both a public mission and private shareholders,” he said Tuesday. The housing mess and quick descent of both GSEs has clearly put Paulson into a position of acting in the short-term to do what he felt was necessary to save the U.S. mortgage market — or at least $5 trillion of it — regardless of his own feelings on the matter. It’s also put him in the position of having to admit, even if only in the short term, that some institutions really are too large to fail. “Of the $5 trillion in debt and mortgage backed securities guarantees issued by these two GSEs, over $3 trillion is held by domestic financial institutions including commercial banks, savings and loans, and credit unions, and over $1.5 trillion is held by institutions and central banks overseas,” he said. “Because of their size and scope, Fannie and Freddie’s stability is critical to financial market stability.” In other words: these birds must fly. They cannot be allowed to fail. And that presents a vexing problem for a man representing an administration that, in any other circumstance, might want to let the GSEs manage their own fate, whatever that may be — his remarks to BusinessWeek on July 21 are telling in this regard. Asked by the magazine’s editors about the long-term prospects for the GSEs, he refused to address his thoughts on the matter, saying only that “my job is to deal with the here and now.” All of which suggests that Paulson is dead serious when he says that he doesn’t expect to use any new-found authority to backstop the GSEs, despite media speculation recently suggesting otherwise. Given the choice, it seems amply clear to us at HW that Paulson wishes he didn’t have to pursue the authority he’s now asking for to begin with, and our sources have suggested to us that the Treasury will be loathe to make any sort of equity investment, especially given the not-precarious existing financial conditions of both Fannie and Freddie. “The administration’s plan seems clear: let’s hope we can put the paddles to this and shock the system enough that we don’t have to actually do any sort of more invasive work,” said one source, an ABS analyst that asked not to be named in this story. Throughout all of this, Paulson has remained amazingly quiet about the Treasury’s plan, and taken heat in the press for doing so. Part of this may be of necessity, but some of HW’s sources suggest it’s also because there is yet hope among administration officials that “this mess will just go away,” as one source put it. After all, in the case of Henry Paulson, it’s never easy to be confronted by the exception to your own world view; and it may also be why he inexplicably suggested Wednesday that the housing mess will resolve itself in the next few months. Disclosure: The author was long FRE and held no positions in FNM when this story was written; further indirect holdings may exist, however, via mutual fund investments. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.