It’s the end of the “American Dream.” It’s the story of how the inevitable bailout of insolvent housing giants Fannie Mae (FNM) and Freddie Mac (FRE) – with the Federal Housing Administration soon to follow – will ultimately lead to such sorrowful sequels as “TheDeath of the Dollar,” “The Downgrading of U.S. Government Debt” and, yes, “The Depression.”

Let’s be very clear on one point, however: There’s no question about it – Freddie and Fannie have to be supported. If the doctrine of “too big to fail” didn’t already exist, it would have to be invented – immediately. Although many are arguing against a “bailout,” those “experts” never seem to address the fallout that would emanate from such a strategy. Nor do they ever discuss the sad series of events that brought us to this financial brink. On that latter point, the truth is so ugly and the failure of governance and its resulting greed so disgusting that to not understand it will guarantee the loss of the American Dream for generations.

Fannie Mae and Freddie Mac: From Dream to Drama

Because it was designed to foster capital creation – and directly promote the American Dream of home ownership, as well as a vibrant economy – the creation of Fannie Mae and Freddie Mac involved some of the best and brightest legislation ever enacted.

That brings us to the most obvious question of all: What went wrong?

First and foremost, both Fannie and Freddie should long ago have been phased out as “government sponsored enterprises,” or GSEs. The implicit (now explicit) guarantee of U.S. government backing allowed the firms to borrow cheaply in the capital markets. If fixed-income (debt) investors – and equity investors as well, for that matter – believe their investments are guaranteed, they will likely invest more and with greater comfort.

The result: These enterprises are able to borrow more cheaply than their rivals – namely banks, investment banks, mortgage companies and other non-bank lenders.

Since Fannie and Freddie were able to borrow more for less, they were also able to post fatter profit margins and dwarfed all potential competitors. The federal government should have gradually unshackled itself from this implicit backing by simply declaring a timetable over which future debt issuance would be explicitly exempt from any government guarantees. This graduated phaseout would have resulted in existing debt being guaranteed up to its maturity, while any new debt would have to be raised competitively, and not at preferential rates. This would have fostered competition, reduced the swelling balance sheets of both enterprises, and kept U.S taxpayers from having to be on the hook for both institutions.

How simple that would have been.

Secondly, and manifestly because of their ability to cheaply fund their balance sheets, both enterprises diverged from their mandates and began to buy and hold the securities they were supposed to create and sell to investors. They bought their own products. The more they created, the more they bought. Ultimately, both enterprises were making more on an operating basis – by fattening their own balance sheets with trillions of dollars of their own securities – than they were making in fees from originating, guaranteeing and selling mortgage debt.

Both enterprises began to borrow aggressively and fund their purchases by borrowing shorter. Their “protected” status enabled them to tap the market whenever they wished.

After recognizing they were creating the classic dilemma of borrowing short and lending long, Fannie and Freddie decided to mitigate their interest rate exposure by hedging with swaps and derivatives. They also bought insurance from the monoline insurers, expecting that their investments would be further protected by these insurers whose own capital was so inadequate that they could never pay 1/100th of their contingent liability exposure.
So, just how big did the balance sheets of Fannie Mae and Freddie Mac actually get? Together, the two housing giants currently guarantee or hold approximately $6 trillion of mortgage-related securities.

Those Missed Opportunities

The capital base underlying their bloated balance sheets was never adequate.

Never.

But again – because of their importance in the grand scheme of capital formation and the implicit government guarantee – investors didn’t focus on their equity or capital base. Just like what happened with technology stocks in the late 1990s, housing prices just kept moving higher.

Both companies saw their share prices escalate as the investments they held made money. Everyone’s eyes were diverted. People were getting rich – debt and equity investors, and especially management.

All hell should have broken loose when, in 2003 and 2004, Fannie Mae suffered from massive accounting scandals. Its top three executives pocketed over $115 million. They were cooking the books. After billions of dollars of the company’s money was spent to “fix” the accounting problems and $400 million of fines were paid by the company, no one went to jail.

Yes, you heard that correctly.

Where were the regulators? Where was the congressional outrage? Where were the analysts and ratings agencies?

There are myriad technical aspects to the workings and investments of both Fannie and Freddie. And there are many questions as to how they were allowed to grow and expose taxpayers to their massive liabilities, and how they are able to manipulate and coddle regulators when it comes to their accounting and specifically their capital adequacy. The day of reckoning has finally arrived. The Painful Payoff of the Fannie/Freddie Debacle Because of the precipitous drop in both companies’ share prices, the resulting erasure of their capital, and the fact that Freddie Mac was yesterday (Monday) scheduled to auction off $3 billion worth of 3-month and 6-month notes (they reportedly sold), the rescue was inevitable. In a classic attempt to calm the markets Sunday, U.S. Treasury Secretary Henry Paulson said the Treasury Department and the Federal Reserve will provide a “liquidity backstop” by offering a line of credit that is “to be determined.” Furthermore, “if needed,” it will supply “temporary authority to purchase equity” in the enterprises. [For a more-detailed story on Treasury Secretary Paulson's bailout plan - including some harsh criticism's from investing guru Jim Rogers, check out our news story on the Fannie Mae/Freddie Mac bailout plan also published in today's edition of Money Morning.]

The Treasury Department and the Fed also will strengthen regulatory measures.
 Now, I’m relieved!

The bailout has begun. The $6 trillion burden will be shouldered by U.S. taxpayers. U.S. debt will double to the equivalent of our gross domestic product (GDP). Borrowing costs will rise for homebuyers, further depressing the housing market and leading to hundreds of billions of additional bank write-offs, hedge-fund losses and failures of financial institutions and enterprises ranging from banks to hedge funds.

The Fed has no concern about inflation relative to the demise of the economy, and will have to keep interest rates low for critical liquidity demands and to stave off a deep recession. The building inflationary pressures in the face of the Fed’s efforts to provide liquidity and keep interest rates low will crush the dollar.

We are facing the prospect of a depression and the end of the American Dream. What can be done? Will the housing legislation on the table be the rescue plan we desperately need?

Absolutely not.

This crisis can’t wait. I’ll address the legislation, why it will fail and what should be done later this week.

Don’t be fooled by any bounce in the markets. Every bounce is an opportunity to sell and add to shorts. This is no time to be picking bottoms. The trend is your friend – and that trend is clearly down.

[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his new column, "Inside Wall Street," Gilani vows to take readers on a journey through the "shadowy back alleys" of the U.S. capital markets - and to conduct us past the "velvet rope" that guards Wall Street's most-valuable secrets - in an ongoing search for the investment ideas with the biggest profit potential.]

News and Related Story Notes:

• Money Morning News Analysis:
  MBIA on the Hook for $7.4 Billion After Moody’s Downgrade.

• MSNBC:
  Report: Fannie Mae Manipulated Accounting.

• RebelTraders:
  Updates on Market, Washington Mutual, Freddie Mac Bond Sale.

• Money Morning Special Investors Research Report:
  Nine Ways to Profit From the Diving Dollar.

• Money Morning Weekly Forecasting Commentary:
  Subprime Crisis Again in the Spotlight as the Meltdowns of Fannie Mae and Freddie Mac Fuel Fears of a Deeper Downturn.

Standing on the steps of the U.S. Treasury building across the street from the White House, Treasury Secretary Henry Paulson asked Congress for the power to prop up Fannie Mae (FNM) and Freddie Mac (FRE), the two failing mortgage giants involved with nearly half of the $12 trillion U.S. mortgage market.

"The president has asked me to work with Congress to act on this plan immediately," Paulson said Sunday. "Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their support for the housing market is particularly important as we work through the current housing correction."

But half a world away – in his new home in Singapore – peripatetic investing guru Jim Rogers blasted the federal government for its new activist approach, which conflict with the very idea of a free market. A rescue of Fannie Mae and Freddie Mac – the second federally sponsored corporate bailout in four months after the Treasury Department rode to the rescue of The Bear Stearns Cos. Inc. (BSR) in March – is shifting the cost of errant financial strategies away from shareholders and onto U.S. taxpayers.

"I don’t know where these guys get the audacity to take our money, taxpayer money, and buy stock in Fannie Mae," Rogers, the best-selling author and famed investor told Bloomberg News. "These companies were going to go bankrupt if [the feds] hadn’t stepped in to do something, and they should’ve gone bankrupt with all of the mistakes they’ve made. What’s going to happen when you … put some Band-Aids on it for another year or two or three? What’s going to happen three years from now when the situation’s much, much, much worse?"

Clearly, a sweeping rescue of the government sponsored entities, such as the one planned, will bring with it a broad new range of liabilities for the American taxpayer, who will be financing institutions that are widely regarded as insolvent.

The debt securities issued by Fannie and Freddie are widely owned by pension funds, mutual funds, institutional investors, and even foreign governments. So a collapse of the two government-sponsored enterprises would send shockwaves through an economy that is already struggling to overcome the worst housing recession in a quarter-century, tight global credit markets and soaring inflation thanks to rising food and energy prices.

Paulson asked Congress for the authority to buy equity in – and lend to – the companies, while also substantially increasing their lines of credit.

The Treasury Department did not specify the amount of credit that would be made available to Fannie Mae and Freddie Mac, but those briefed on the plan told the International Herald Tribune that administration officials are lobbying Congress to extend the line of credit to $300 billion.

Each company currently has a $2.25 billion credit line that was established close to 40 years ago. At the time, Fannie Mae had only $15 billion in outstanding debt according to IHT.  Now, Fannie has a total debt of about $800 billion and Freddie has roughly $740 billion.

Many on Capitol Hill, particularly Senator Charles Schumer (D-NY), greeted the plan with enthusiasm.

"The Treasury’s plan is surgical and carefully thought out and will maximize confidence in Fannie and Freddie while minimizing potential costs to U.S. taxpayers," Schumer said.

"While Fannie and Freddie still have solid fundamentals, it will be reassuring to investors, bondholders and mortgage-holders that the federal government will be behind these agencies, should it be needed."

But Rogers – who contends that the U.S. economy is in the midst of its worst recession since World War II – referred to Paulson’s plan as an "unmitigated disaster."

"They’re ruining what has been one of the greatest economies in the world," Rogers said, making a collective reference to both Paulson and U.S. Federal Reserve Chairman Ben S. Bernanke.

 Said Rogers: Paulson and Bernanke "are bailing out their friends on Wall Street … but there are 300 million Americans that are going to have to pay for this."

[Editor's Note: For an insider's explanation of the catalysts for the Fannie Mae/Freddie Mac financial crisis - as well as the long-term fallout investors can expect - check out Contributing Editor Shah Gilani's " Inside Wall Street" column also contained in this issue of Money Morning. Global Investing guru Jim Rogers has been particularly critical of the U.S. government's willingness to bail out Wall Street's financial miscreants. Indeed, in an exclusive interview with Money Morning earlier this year, Rogers predicted the failure of the U.S. Federal Reserve for this very reason. And while that's very bad news for U.S.-focused investments, there is an alternative - Asia, and more specifically, China, Rogers says. For more details of this global investing game plan, and to obtain a free copy of Rogers' new bestseller, "A Bull in China," check out this investing report.]

News and Related Story Links:

• Bloomberg:
  Fannie Plan a ‘Disaster’ to Rogers; Goldman Says Sell.

• Money Morning Exclusive Interview:
  Jim Rogers: More Pain for the Greenback, and the Failure of the Federal Reserve.
• International Herald Tribune:
  U.S. unveils vast plan to save mortgage giants.
• Money Morning:
  Freddie Mac and Fannie Mae Rocked by Liquidity Concerns

Speculation that the U.S. government would have to step in to bail out struggling mortgage-giants Freddie Mac (FRE) and Fannie Mae (FNM) escalated as the markets set to close for the weekend.

Shares recovered slightly after Reuters reported U.S. Federal Reserve Chairman Ben S. Bernanke granted Freddie Mac and Fannie Mae emergency access to the Fed’s discount window.

Freddie Mac shares pared earlier losses to shed just $0.25 Friday, a 3% decline, to close at $7.75. Earlier in the day, the stock had traded as low as $4.01. Freddie Mac is down over 77% year-to-date as of Friday’s close. The stock has traded between $3.89 and $67.20 over the past 52 weeks.

Fannie Mae stock had a similar fate, shedding $2.95, a 22% to decline to close at $10.25, after climbing from $7.25 in early hours trading. Fannie Mae shares are down 45% in the past week and 74% year-to-date. Shares have traded between $6.68 and $70.57 over the last 12 months.

Rumors of a government-sponsored bailout swirled, with The New York Times reporting that President Bush & Co. were mulling over options. But Citigroup Corp. (C) issued a bold research note supporting the two government-sponsored entities (GSEs) in their current incarnations.

"We believe that no one in Washington desires for a nationalization of the GSEs, which would bring the burden of providing mortgage access and liquidity on to the shoulders of taxpayers," Citigroup Global Markets analysts Bradley Ball and Arren Cyganovich wrote in a research note Friday concerning Freddie Mac and Fannie Mae.

"We believe the market needs to be reminded that the GSEs were structured as shareholder-owned institutions for a reason – to provide non-federal capital support for the U.S. housing and mortgage markets, and that the GSE structure has worked in the past (such as during 1998) and continues to work today," the analysts continued, MarketWatch reported.

And while it’s true that the government might be hesitant to step in after what many considered a taxpayer-sponsored bailout of The Bear Stearns Cos. Inc. (BSC), it’s also true that the government can’t afford to let Freddie Mac and Fannie Mae fail. Together, the two lenders guarantee about half of the $12 trillion U.S. home mortgage market.

"The impact of a failure of Fannie and Freddie, though technically insolvent, is beyond imagining, far greater than the bankruptcy of a Bear Stearns," said Barron’s Randall W. Forsyth on Friday. "For that reason alone, such an eventuality is unthinkable."

Foreclosures Hit Fannie Mae and Freddie Mac in the Bottom Line

Rocketing foreclosure rates are only serving to exacerbate the problems of the largest U.S. lenders as one in every 501 households was at some stage of the foreclosure process in June, industry watchdog RealtyTrak announced Thursday.

"The foreclosure problem is getting worse and will stay with us well into the next decade," Mark Zandi, chief economist for Moody’s Economy.com (MCO) said in an interview with Bloomberg News. "The job market is eroding and homeowners have less equity. Lenders are much less willing to work with you if you’ve got negative equity, and you’re more likely to give up your house if you’re deeply underwater."

U.S. Treasury Secretary Henry Paulson tried to reassure investors about Freddie Mac and Fannie Mae, saying both firms remain "adequately capitalized," The New York Times reported.

"Fannie Mae and Freddie Mac are also working through this challenging period," Paulson said in testimony before the House Financial Services Committee earlier this week. "They play an important role in our housing markets today and need to continue to play an important role in the future."
But former St. Louis Federal Reserve President William Poole questioned the solvency of Freddie Mac and Fannie Mae, saying the government might need to step in to rescue the struggling lenders.

"Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer," Poole, who left the Fed in March, said in the interview Wednesday, Bloomberg reported.

Poole has long been a critic of Freddie Mac and Fannie Mae, saying as early as 2003 that the companies would not be able to weather a serious market destabilization.

While the two firms are considered government-sponsored enterprises, neither Freddie Mac nor Fannie Mae receives funding from the U.S. government. Likewise, the government does not guarantee any debt-issued by the firms.

"At some point we’re going to reach that inflection, where the government is going to have to either guarantee explicitly or Fannie and Freddie are going to have be left to fend for themselves," Peter Boockvar, an equity strategist at Miller Tabak & Co. in New York, said in an interview with Bloomberg Television. "We’re getting to that point where a decision has to be made by Washington."

News and Related Story Links:

• Money Morning:
  Freddie Mac and Fannie Mae Rocked by Liquidity Concerns

• MarketWatch:
  Citi analysts say Fannie, Freddie selling ‘overdone’

• Barron’s:
  Failure Is Not an Option For Fannie and Freddie

• Reuters:
  Fannie, Freddie stocks and bonds plummet

• Bloomberg News:
  Foreclosures Rose 53% in June, Bank Seizures Triple

• The New York Times:
  Fannie Mae and Freddie Mac Shares Tumble

• Bloomberg News:
  Fannie, Freddie Tumble on Bailout Concern, UBS Cut

Investor worry over the solvency of U.S. mortgage-giants Freddie Mac (FRE) and Fannie Mae (FNM) have gutted the stocks over the last few days more than halving their market capitalizations.

News of a possible government-sponsored bailout sent Freddie Mac and Fannie Mae shares plunging yesterday (Thursday) dangerously close to new 52-week lows.

Freddie Mac shares sank $2.15 yesterday, a 20% decline to close at $8.11. Freddie Mac is down 76% year-to-date as of Thursday’s close.

Fannie Mae stock had a similar fate, shedding $1.95, an almost 13% to decline to close at $13.36. Fannie Mae shares are down nearly 67% year-to-date.

Rocketing foreclosure rates are only serving to exacerbate the problems of the largest U.S. lenders as one in every 501 households was at some stage of the foreclosure process in June, industry watch-dog RealtyTrak announced yesterday.

“The foreclosure problem is getting worse and will stay with us well into the next decade,” Mark Zandi, chief economist for Moody’s Economy.com (MCO) in West Chester, Pennsylvania, said in an interview with Bloomberg News. “The job market is eroding and homeowners have less equity. Lenders are much less willing to work with you if you’ve got negative equity, and you’re more likely to give up your house if you’re deeply underwater.”

U.S. Treasury Secretary Henry Paulson tried to reassure investors about Freddie Mac and Fannie Mae yesterday, saying both firms remain “adequately capitalized,” The New York Times reported.

“Fannie Mae and Freddie Mac are also working through this challenging period,” Paulson said early in his testimony before the House Financial Services Committee. “They play an important role in our housing markets today and need to continue to play an important role in the future.”

But former St. Louis Federal Reserve President William Poole questioned the solvency of Freddie Mac and Fannie Mae, saying the government might need to step in to rescue the struggling lenders.

“Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer,” Poole, who left the Fed in March, said in the interview Wednesday, Bloomberg reported.

Poole has long been a critic of Freddie Mac and Fannie Mae, saying as early as 2003 that the companies would not be able to weather a serious market destabilization.

While the two firms are considered government-sponsored enterprises, neither Freddie Mac nor Fannie Mae receives funding from the U.S. government. Likewise, the government does not guarantee any debt-issued by the firms.

“At some point we’re going to reach that inflection, where the government is going to have to either guarantee explicitly or Fannie and Freddie are going to have be left to fend for themselves,” Peter Boockvar, an equity strategist at Miller Tabak & Co. in New York, said in an interview with Bloomberg Television. “We’re getting to that point where a decision has to be made by Washington.”

News and Related Story Links:

• Reuters:
  Fannie, Freddie stocks and bonds plummet

• Bloomberg News:
  Foreclosures Rose 53% in June, Bank Seizures Triple

• The New York Times:
  Fannie Mae and Freddie Mac Shares Tumble

• Bloomberg News:
  Fannie, Freddie Tumble on Bailout Concern, UBS Cut

A loosening of government restrictions announced yesterday (Wednesday) for Fannie Mae (FNM) and Freddie Mac (FRE) has freed up an estimated $200 billion to boost the flagging mortgage market.

The Office of Federal Housing Enterprise Oversight (OFHEO) announced it is reducing the capital surplus requirement of both Fannie Mae and Freddie Mac to 20% from 30% – a move that will immediately free up billions in capital for the two mortgage giants to offer affordable loans to homeowners desperate to refinance.

"We believe they can play an even more positive role in providing the stability and liquidity the markets need right now," OFHEO Director James Lockhart said in a statement.

Story Continues Below…

Sign up right now, and we’ll send you an important new report for free: "The Three Best Investments in Asia."

Freddie Mac and Fannie Mae are both government-sponsored enterprises and had been required to hold capital surpluses above normal standards due to a prior accounting scandal. Lockhart was quick to assure that both firms would still maintain an adequate liquidity cushion at the new reduced levels.

Treasury Secretary Henry Paulson welcomed the move, saying that freeing up additional capital "will enable the companies to help more homeowners and will strengthen the underlying fundamentals of the mortgage market," MarketWatch reported.

The latest move comes on the heels of an OFHEO decision to raise the cap on mortgages that the companies can purchase or guarantee, from $417,000 to $729,750 in high-cost markets, The Washington Post reported. As of March 1, the restriction to hold the two companies to a combined cap of $1.5 trillion in mortgage-investment holdings was also abolished.

The combination of these efforts mean Freddie Mac and Fannie Mae could purchase or guarantee as much as $2 trillion in mortgages.

The goal is to "help restart the housing engine that powers our economy," Fannie Mae Chief Executive Officer Daniel Mudd said at a news conference in Washington yesterday, Bloomberg News reported.

News and Related Story Links:

• The Washington Post:
  Gov’t Gives Plan to Help Fannie, Freddie

• MarketWatch:
  Fannie, Freddie get OK to buy more mortgages

• Bloomberg News:
  Fannie, Freddie Surplus Capital Requirement Is Eased

Freddie Mac (FRE) management is committed to putting shareholder interests ahead of the flagging housing market, according to the mortgage lender’s Chief Executive Officer Richard F. Syron.

Speaking yesterday (Wednesday) before a group of analysts in New York, Syron reiterated his firm’s commitment to its shareholders. He said the mortgage giant does not have plans to raise additional capital in order to take on more subprime mortgages despite how such actions might help the troubled housing market.

"It is not good public policy to have mission goals that encourage [Freddie Mac and Fannie Mae] to put people in homes that they end up losing," Syron said, according to The Washington Post. "We have to do things that make sense and will help the economy of the United States," not hurt it in the pursuit of "what could be unrealistic goals."

Increasing Freddie Mac’s cash reserves would allow it to purchase additional mortgage-backed securities, but it would also add to the risk of its portfolio. That’s a risk Syron is not willing to foist onto Freddie Mac shareholders.

Syron also forecasted that housing prices, which are already down 2.5% from their peak according to the Office of Federal Housing Enterprise Oversight, have further to fall. He estimated that home prices would eventually decline by 15% from their peak, MarketWatch reported.

Shares of Freddie Mac soared almost 16% on Tuesday, the day of the U.S. Federal Reserve’s announcement that it would inject an additional $200 billion in liquidity into the crippled credit markets.

Patricia L. Cook, Freddie Mac’s chief business officer addressed the Fed’s plan to boost liquidity in today’s briefing. She described the Fed’s plan as "a short-term help" but added that "it doesn’t solve the long-term problem."

"The longer term issue is where do those mortgages ultimately end up," she said.

Shares of Freddie Mac closed at $20.04 yesterday, down 12 cents for the day. The stock has traded in a range of $16.59 to $68.12 in the past 52 weeks.

News and Related Story Links:

• The Washington Post:
  Freddie Mac Chief Resists Calls To Boost Capital

• MarketWatch:
  Freddie Mac sees home prices falling further

• Money Morning:
  Fed Plan Sends Dow Soaring Over 400 Points