Editor's Note: This is Part 2 of a 2-part series. Part 1 can be found here.

The Fannie (FNM) and Freddie (FRE) bailout shows just how severe the problems facing the and global financial system have become.

The mortgage market -- especially the higher quality mortgage (prime and Alt A) market -- has deteriorated as the economy slows, unemployment rises, house prices decline and credit becomes less and less available. The GSE rescue may presage further bank write-offs.

The banking system requires new capital to cover losses and involuntary asset growth (returning "off-balance-sheet" assets previously held in the "shadow banking system" (Collateralized Debt Obligations or CDOs, ABS, Structured Investment Vehicles (SIVs) and hedge funds).

The government bailout comes after the failure of the search for a buyer or major equity investor to recapitalize the GSEs. The reluctance of the usual suspects -- sovereign wealth funds and Chinese banks -- to act as "sugar daddy" doesn’t bode well for future capitalization by financial institutions.

Credit default swaps (or CDS) on Freddie and Fannie (a form of credit insurance) have been triggered as a result of the conservatorship, necessitating settlement of around $500 billion to $1 trillion in contracts.
 


Expected losses are unknown, though they will not be insignificant, as was thought when Fannie and Freddie debt was expected to trade around face value or 100%. However, even at a trading level of 95%, the losses would total $25 billion on $500 billion in contracts.

Settlement of the CDS contracts may limit any decline in credit spreads on GSE debt. Government support for GSE-subordinated debt appears to be designed to avoid the possibility of triggering large losses on CDS contracts. At a minimum, settlement of the CDS contract will impede progress on restructuring Fannie and Freddie. It also poses questions on the effectiveness of CDS contracts in transferring risk of default generally.

The GSE saga exposes systemic problems for the United State . The size of bailout and the ultimate cost to the taxpayer is difficult to quantify. Henry Paulson didn’t mince words on CNBC on the cost of the rescue: "We didn’t sit there and figure this out with a calculator."

The commitment of the treasury is $100 billion, as compared with the $ 250 billion cost (in current dollars) of the S&L scandal in the 1980s.

This doesn’t include funding under the secured credit facility. That amount is unspecified, but may be up to the $1.4 trillion MBS portfolio held by the GSEs that can be pledged as collateral. When added to the $400 billion of funding provided by the Federal Reserve to the financial system, the sums involved aren't trivial.

The authorities argue that the risk of loss is low because the loans are secured against high-quality ABS securities. Based on the price of similar securities in actual transactions (e.g. Merrill Lynch’s (MER) sale of a portfolio to Lone Star), current market values may be below levels assumed by the central bankers. The authorities may have to hold the securities to maturity and allow the underlying cash flows to repay their loans. The risk of actual losses cannot be entirely discounted.

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