Fannie Mae and Freddie Mac made the giant crazy sized long running American real estate bubble all possible. Released by congress from capital-ratio requirements and backed with a line of credit at the Treasury, they were able to buy a nearly unlimited amount of mortgages, which kept home mortgage financing flowing to a lot of people who had no ability to repay the mortgages. Today, Freddie or Fannie finance more than 80% of all new mortgages in the United States.

Fannie Mae purchases and guarantees mortgages that meet its funding criteria. Through this process it secures mortgages to form mortgage-backed securities (MBS). Fannie Mae is not required to file regular financial reports with the Securities and Exchange Commission (SEC), although in 2002 it began to do so under pressure from SEC and Congressional investigators. In 2004, the SEC required Fannie Mae to restate several years of earnings statements, alleging that previously reported profits were in fact multi-billion dollar losses. Fannie Mae’s long been a cat in desperate need of having a bell tied to it. Freddie Mac is Fannie’s twin brother.

Over the last several decades, their presence in the market greatly lowered interest rates, created an endless supply of credit, and pushed housing prices higher and higher. Meanwhile, the cost of the government guarantee, which lay behind Fannie and Freddie’s power, was invisible.

What is next now that the US housing bubble has gone bust?

The size of the bailout of Fannie Mae and Freddie Mac could easily surpass $1 trillion.  In my opinion, the US Congress has little if any understanding of what’s about to happen. With the American housing market still in free fall the American real estate market could take many years, even decades, to recover. By giving Fannie Mae and Fannie Mac access to even more credit Congress is only pumping up the dark twin towers of financial mismanagement so that the final fall will be truly monumental. Unfortunately, it will also be devastating to the American economy.

Stock market investors know that something has gone terribly wrong. While shares of Freddie Mac and Fannie Mae have bounced somewhat from their lows on the back of Hank Paulson’s overly optimistic congressional testimony Fannie Mae shares at one point fell to all of $7.87. Freddie Mac shares declined to below $5.00. Technically both companies are bankrupt with liabilities far exceeding their assets.

Fannie Mae and Freddie Mac are the nation’s largest buyers of home mortgages, and traditionally the government’s backstop for the housing economy. But with their recent plunge, each of these giants has now lost more than 70 percent of its market value this year. Fannie Mae and Freddie Mac were chartered by Congress as government-sponsored enterprises, or GSEs, which gives them a quasi-governmental status. Both are in the same business: They buy home loans from lenders, then hold them in their portfolios or repackage them into bonds — known as mortgage-backed securities — that are traded on Wall Street.

Fannie Mae has its roots in the New Deal, when it was established to increase the amount of money available for mortgages. Over the years, its main business has been to issue debt and then use the proceeds to buy mortgages from lenders, allowing those lenders to give out new mortgages. Fannie Mae makes a profit from the difference between the interest rates homeowners pay and foreign lenders charge.

Fannie Mae may be one of the most ill-fated welfare creations, ever, on the part of the United States government. In the beginning, Fannie Mae’s impact was negligible, however, from the outset there were plans to swell Fannie’s waistline by expanding her purchasing authority. Fannie Mae was thus in the rather bizarre position of guaranteeing an ever increasing portion of its own assets against default. Fannie Mae’s customers include mortgage banking companies, investment banks, savings and loan associations, savings banks, commercial banks, credit unions, community banks, insurance companies, and state and local housing finance agencies. The company was founded in 1938 and is based in Washington, the District of Columbia.

Fannie Mae has a federal charter and operates in America’s secondary mortgage market to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates. 2008 marked the 70th year of service, or given recent events perhaps disservice, to America’s housing market. The trouble with Fannie Mae and Freddie Mac will soon return as an even more difficult financial problem and this will continue until they either fail or the federal government admits its mistake and puts them out of our misery.

Currently these are private companies to which the US Government does not have exposure. Should the government take over the companies, they effectively take on an additional $5 Trillion in debt that was not on their books. This would just about double the already unmanageable federal debt.

As a result American monetary policy may become constrained. America is not the only country that would feel pain from the failure of Freddie and Fannie. According to data from the Council on Foreign Relations, central banks own $925 billion in debt in the two companies. Americans are little aware of how much they rely on federal assistance to help pay for a home. The mortgage crisis has finally caught up with two government-backed giants in home finance.

Secretary Paulson dreams of “a new world-class regulator” for the troubled enterprises. Their current regulator, the Office of Federal Housing Enterprise Oversight is apparently too old at age 16 and not “world class.” But regulation of Fannie and Freddie has always been heavily politicized, and there is no reason to expect that to change under a new entity.

Congressman Christopher Shays was lying in bed one night last March and told his wife he was about to take on a new battle. He said the Enron scandal had gotten him thinking about Fannie Mae and Freddie Mac, the two government-chartered housing-finance corporations. Congress, and only Congress, can address this issue for a permanent fix. The Fed can only provide some temporary relief. Unfortunately, Congressman Shays has little chance of being successful with a true fix for Fannie Mae and Freddie Mac. A $5 trillion bite is a bit too large even for the US government.

Potential home buyers are finding it increasingly difficult to get mortgages as wary lenders toughen their lending standards. With Dodd and Frank putting their weight behind a new housing proposal, it could move through Congress relatively quickly. As it stands now, the current housing package has won strong bipartisan support in the Senate. Dodd is the one that kept giving them extra ability to absorb losses. Just wait as Dodd “blames” the watchdog for this one as the congressional emergency package fizzles out. Neither Dodd or his partners in crime in the US Congress have any real idea as to how big the Fannie Mae and Freddie Mac monster has become.

Any government bailout will leave the shareholders of Fannie Mae and Freddie Mac stock wiped out. The stocks will be worth zero. If the US government is foolish enough to take the $5 trillion of Freddie Mac and Fannie Mae debt onto its own books you can say goodbye to what is left of the US Dollar. I doubt that the kindness of foreign countries in pegging their currencies to a US Dollar and in continuing to lead the US vast sums of money would continue for more than a New York minute.

As US interest rates go through the roof the Dollar would lose its privileged reserve currency status and the United States would quickly enter into an inflationary environment that would seriously challenge the republics survival, at least in a form that would be recognizable. It would be the worse of all economic worlds, stagflation on steroids.

The best thing to do with Fannie Mae and with Freddie Mac is to let them fail even as they are now considered too big to let fail. As painful as that course of action would be to the US economy the consequences would likely be far less than a $5 trillion dollar attempted bailout. That would amount to financial suicide for the United States.

To be sure whatever the future brings with Fannie Mae and Freddie Mac in the picture it is going to be messy and full of pain. Congress has no idea as to the wrath and destrutive potential of the two monsters they have created.

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