The taxpayer wards have gotten billions in bailouts in the name of preventing a mortgage meltdown and housing collapse. And now Congress is looking for a solution.

And now, fresh off passing the 2,300-page Dodd-Frank Wall Street Reform and Consumer Protection Act, Congress promises to address the "problem" of Fannie Mae and Freddie Mac.

Be afraid. Be very afraid.

Oh, not because Fannie Mae and Freddie Mac don't need to be reformed. They sure do.

And not because Congress can be counted on to compromise its way into a hash that combines the worst of private-market gestures with the worst of bureaucratic rule splitting.

No, the real danger is that a mistake in fixing Fannie and Freddie could take down the Federal Reserve. Or at least take down the Fed to the degree that any central bank, with a central bank's ability to create money, could be taken down.

All hyperbole aside, a mistake in fixing Fannie Mae (OTCBB: FNMA) and Freddie Mac (OTCBB: FMCC) could throw the US financial system into crisis again by destroying the Fed's balance sheet.

The two entities—I don't know quite what else to call them now that the one-time government agencies turned publicly traded companies have turned into wards of the taxpayers—played a central role in the housing bubble that led to the global financial crisis. By using an assumed government guarantee to raise cheap money from investors who persisted in thinking that so-called agency paper was like US Treasury notes, Fannie and Freddie enabled mortgage lenders to pass on a riskier and riskier mix of mortgage paper to the financial markets.

Somebody Else's Risk

If you can pass on risk to someone else, the temptation to make more money by taking on increasingly greater risk—for someone else—is almost irresistible. Certainly, few mortgage lenders were able to fight the urge. The result was shoddy underwriting that, at its worst, wrote mortgages to any borrower with a pulse—even if he or she didn't have an income, a credit rating as high as the mortgage banker's IQ, or any real need for the money.

Now, as a result of the mortgage debacle and the global financial crisis, private mortgage lenders have pretty much stopped lending. In the first quarter of 2010, Fannie and Freddie—plus Ginnie Mae, which had an explicit government guarantee even before the crisis—guaranteed 95% of all mortgage originations in the United States. In other words, in the first quarter, Fannie, Freddie, and Ginnie were the mortgage industry.

Or maybe, more accurately, US taxpayers were the mortgage industry. The federal government took over Fannie Mae and Freddie Mac in 2008, and taxpayers now own about 80% of them.

What do we own? It's not pretty. Fannie Mae owns or guarantees almost half of the $10 trillion in outstanding US mortgages. But at the end of the first quarter, Fannie and Freddie reported $330 billion in non-performing loans. And that portfolio is likely to get worse before it gets better.

A Lesson Learned Too Late

In 2008, once the damage was done, Fannie and Freddie began tightening their standards for mortgages and raised the fees they charge to guarantee bundles of mortgages wrapped up into mortgage-backed securities. For example, in 2007, 10% of mortgages at Fannie and Freddie were for 95% or more of the value of the house. By 2009, that 10% had dropped to just 1%.
 
But the damage to the loan portfolios from pre-2008 lending practices is staggering. At the end of March, about 4% of the mortgages originated by Freddie Mac in 2008 were delinquent by at least 90 days. For mortgages originated in 2009, the figure was less than 0.1%.

That's swell—except that Fannie and Freddie guaranteed a huge number of mortgages in the boom years of 2006 and 2007. Mortgages originated in those two years make up 24% of Fannie Mae's business, for example, but account for 67% of its credit losses.

So far, propping up Fannie Mae and Freddie Mac by providing them with the money to cover losses and stay in business has cost taxpayers $145 billion.

Estimates of the total cost to taxpayers come in all over the block because they're all based on guesses about when the US economy—and the US housing market—will improve and how fast that improvement will be.

The White House estimates a total bailout cost of $160 billion. (Let's see, we're at $145 billion, and defaults are accelerating for prime mortgages. I'll be kind and say $160 billion is unlikely. For more on the rising number of the "best" mortgages that are now going bad, see this post on my Web site.)

The Congressional Budget Office puts the cost at $389 billion (.pdf file) through 2019. Barclays Capital says the cost could rise to as much as $500 billion if housing prices fall by 20% from the levels of the end of 2009 and default rates triple.

The truth is that nobody knows exactly, but it'll be a big figure.

NEXT: The Rest of the Problem

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The Rest of the Problem

And that's really only part of the balance sheet. Sending truckloads of taxpayers' money to Fannie and Freddie was only part of the effort to prop up these entities in order to prevent the meltdown of the mortgage market and the collapse of the housing industry.

The Federal Reserve also rode in to the rescue. While taxpayers provided billions so Fannie and Freddie could keep guaranteeing mortgages, the Federal Reserve stepped in as a buyer to preserve at least the illusion of a market for the resulting paper.

According to its news release after its March 18 meeting, the Fed has purchased $1.25 trillion of Fannie Mae and Freddie Mac mortgage-backed securities and bought an additional $175 billion of debt from those two entities.

That puts the Fed's balance sheet on the hook if anything goes wrong in the mortgage market. Or with a fix of Fannie Mae and Freddie Mac.

What could go wrong?

Normal stuff, like an increase in interest rates. An increase in interest rates pushes down the price of existing bonds and other yield instruments—such as mortgage-backed securities. An interest-rate increase of one percentage point would deliver a $50 billion haircut to the Fed's Fannie Mae and Freddie Mac portfolio.

I'm not too worried about this. Not because it can't or won't happen, but because it falls into the category of predictable bad news. The Fed has a ton of people who spend all their time worrying about the effect of interest rates on things that include the US economy and, by the way, the Fed's portfolio. The Fed may not be able to control the direction of long-term rates (the central bank sets only short-term rates), but it's unlikely to get blindsided by the effect of interest rates on its own portfolio.

Reform—a word that covers a multitude of sins, good intentions and botched legislation—is a far different matter. Once you start making changes in a market, then you leave yourself wide open to unintended and unanticipated effects.

That's including—and this is what worries me most—the possibility that some change will make investors lose all confidence in a market that is finally showing tiny signs of returning confidence. Remember that in the first quarter Fannie, Freddie, and Ginnie made up 95% of the mortgage guarantee market? Well, in the second quarter, that figure dropped to somewhere around 85%. (I say "somewhere" because the data are not terribly reliable.) That's not a huge change, but it is progress.

What would happen if "reform" hit the Fed's portfolio hard? In the short term, not much. The Fed is able to create money. It doesn't face capital requirements like private banks do. Reporting and transparency standards are laughable by corporate standards.

But the long-term effects would be tremendous. At a time when the world is increasingly worried about the fiscal soundness of the United States, a major ding to the Fed's balance sheet would further undermine US financial credibility. Overseas investors would rightly worry about the Fed managing the money supply for the benefit of its own balance sheet. I'd worry about the possibility that the Fed would manage the economy with one eye on its own balance sheet.

So, Now What?

You can make—well, I would make—a pretty strong case that bailing out Fannie Mae and Freddie Mac in the middle of a financial crisis and with housing prices plunging was the right thing to do. I wince when I think of sending $145 billion (and counting) of our money down this rathole, but not doing it would have hurt too much of the economy at a time when the economy was teetering. The time to install fire alarms is before the fire. Once the building is burning, the job is to put out the fire.

And then you fix the problem that caused the fire.

But Fannie Mae and Freddie Mac need more than fixing; they need to be dismantled. The capital markets during normal times are up to the job of setting mortgage prices (otherwise known as interest rates), and private companies can price mortgage guarantees with less distortion than can entities that believe they can tap into the US Treasury. Certainly, linking an implicit government guarantee with private, for-profit companies, as Fannie Mae and Freddie Mac once were, has proved to be a really, really bad idea.

But making that fix or dismantling the two companies would require a delicate hand on the controls. It would require setting up a mechanism for selling off the current portfolios at Fannie and Freddie without sinking the market for mortgage-backed securities and the Fed's balance sheet. And it would require a transition period that lets private companies gradually move to provide the services to the market that Fannie Mae and Freddie Mac once did. Many countries in the world get along just fine without anything like the government participation in the housing market represented by Fannie and Freddie, and they have homeownership rates comparable to the United States'.

All that would require a delicate hand capable of dealing in nuances and adept at making midcourse adjustments.

Instead, we have Congress.

At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.

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Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.