Over the past few weeks, the global financial crisis has entered a new, more dangerous phase. Congress seems likely to act on Treasury Secretary Hank Paulson’s request for a blank check to rescue the troubled government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. As a result, it also seems likely that significant government funds will be at risk.

Curiously enough, the best explanation of these events comes from the theory of exchange rate crises. Economists have spent considerable time trying to understand why investors test a government’s resolve to protect a pegged exchange rate. The answer involves the interactions between a country’s financial resources and forward-looking asset markets.

There are two main types of crises. In a “first-generation” or fundamentals-based crisis, investors choose to flee from a currency, or actively speculate against it, because they correctly recognize that the country’s policies will not support a fixed exchange rate forever. Leaving the fixed exchange rate regime is inevitable, but the timing can be forced by market participants when they sense the government’s vulnerability. In the corporate world, if a company’s debt service is so rickety that eventually it will become insolvent, investors will flee as soon as they realize that. They will not wait until the corporate cupboard is bare.

The assumption is that the financial woes of the GSEs derive from speculative withdrawal rather than from weak fundamentals. But this assumption might be wrong.

In a “second-generation” or self-fulfilling crisis, speculators are in the driver’s seat. A country’s resources might be sufficient to maintain an exchange rate peg indefinitely, as long as the country is not forced to pay an unduly high risk premium in markets. But if investors come to doubt its ability to defend the peg, those doubts become self-fulfilling and the risk premium balloons. In other words, the peg does not hold because investors doubt that it will.

Similarly, a company might be viable as long as it can roll over maturity debt. If investors trust the firm to be viable, it can access markets. However, if its survival comes into doubt, the markets will be shuttered and, eventually, so too will the firm.

Secretary Paulson has been working on the assumption that the travails of Fannie and Freddie stem from a self-fulfilling speculative attack: in other words, that this is a “second-generation” crisis. If that is true, those speculators can be beaten back by an overwhelming show of force. Thus, the Federal Reserve has thrown open its discount window to the GSEs and the Bush administration has sought from Congress an unlimited authority to lend to Fannie and Freddie. The Fed and the White House hope this will convince market participants that GSE debt will always be honored and that all maturing obligations can be rolled over at narrow spreads to Treasuries. The mere possibility of a massive governmental infusion of funds should squash the crisis of confidence without any need for disbursement.

Meanwhile, the Securities and Exchange Commission (SEC) has prohibited the “naked” short selling of the shares of certain financial firms, including those of Fannie and Freddie. (A naked short sale involves selling an equity you do not have in your possession.) In addition, the SEC is apparently becoming more aggressive in dealing with rumor-mongering among traders.

Again, the assumption is that the financial woes of the GSEs derive from speculative withdrawal rather than from weak fundamentals. But this assumption might be wrong. Fannie and Freddie are called the two housing giants for a good reason: they own or guarantee over $5 trillion worth of U.S. mortgages—more than half the market. Which means they have a large, under-diversified exposure to a sector that has plummeted.

Mistaking a “first-generation” crisis for a “second-generation” crisis is a lot like countersigning a loan for a relative who turns out to be feckless. Three unfortunate developments ensue.

First, the relative gets access to more credit for a longer time. Second, when the crunch comes and repayment is sought, lenders are much less likely to settle for anything less than one hundred cents to the dollar. And third, there is likely to be bad blood in the family when you ultimately write a check you had not anticipated.

Secretary Paulson is granting the mortgage twins some running room. That gives them time to run up more debt. Paulson has also emboldened creditors to expect nothing less than full payment from the federal government—and yet his analysis may foster the expectation that no actual payment will be necessary. If this expectation proves wrong, that will make for one unhappy family.

How unhappy might the political family get? The Congressional Budget Office (CBO) estimates that if the proposed GSE bailout legislation were enacted, it could cost some $25 billion in fiscal years 2009 and 2010. In producing this estimate, the CBO stipulated that there is better than a 50 percent chance that investor confidence will recover enough that no outlays are necessary. Put differently, it is a little more likely than the flip of a coin that this is a “second-generation” crisis. But if the other side of the coin turns up, we will be living through a “first-generation” crisis that requires outlays north of $50 billion.

Vincent R. Reinhart, a former director of the Federal Reserve’s division of monetary affairs, is a resident scholar at the American Enterprise Institute.

Photograph by Getty Images.