How the once-mighty have fallen! Last Wednesday, TheWall Street Journal reported that the chief regulator for Fannie Mae (NYSE:FNM) and its sibling Freddie Mac (NYSE:FRE) said that the government-sponsored entities' (GSEs) activity should be curtailed, but that they should retain the ability to provide liquidity to the home-mortgage market during periods of financial distress. The GSEs have many staunch supporters in Congress, and negotiations on legislation defining the appropriate size of their mortgage portfolios are still under way. Nevertheless, the reporting of Office of Federal Housing Enterprise Oversight director James Lockhart's remarks as a sign of possible compromise demonstrates the degree to which the ground has shifted beneath these housing-market institutions over the last few years.

First, a quick review of the facts as they pertain to Fannie Mae; Freddie's case is quite similar (for a primer on their business, see this article by Bill Mann). At the end of 2004, the SEC ruled that the company had violated accounting rules in order to smooth its reported earnings, requiring Fannie to restate historical earnings. Since then, the CEO and CFO have resigned, and the company has agreed to meet higher capital requirements and overhaul its internal controls. In May of this year, Fannie reached a settlement with regulators which includes a $400 million fine. Company estimates for its aggregate earnings restatement amount to $11 billion.

These events illustrate the way in which even a seemingly impregnable competitive position can deteriorate. Fannie and Freddie enjoyed a government-sanctioned quasi-duopoly -- they were able to borrow at lower cost, thanks to the market's perception that its mortgage securities had the implicit backing of the federal government. That's not as good as actually owning a license to print money, but it's the next best thing: Everyone believes you own the license. However, when a private-sector organization is thought to be "too big to fail," it creates a moral hazard by skewing the relationship between business risk and reward. As regulators examined the accounting violations, they found evidence of greed, mismanagement, and excessive risk-taking. They concluded that the size and leverage of the GSEs mortgage portfolios must be reduced in order to mitigate any systemic risk (a fancy way of saying that in the hypothetical event of Fannie Mae's failure, widespread disruption in the financial markets or the economy could ensue).

If I analyze Fannie Mae as a business rather than a government program (and how else should investors evaluate it?), I can't find any competitive advantage, aside from favorable borrowing costs based on the perception of implicit government backing. There is no evidence that it has developed specific expertise that doesn't exist elsewhere. Does anyone believe that Lehman Brothers (NYSE:LEH) or Bear Stearns (NYSE:BSC) are less proficient at securitizing loans and managing large and complex bond inventories? So when the government signals that it is uncomfortable with a guarantee that it never gave, and wants to reduce the influence of the GSEs, investors must take a hard look at these companies' business models. This isn't a mortal wound, but these firms clearly aren't operating from the same position of strength they once had, and we must expect future results to reflect this.

Of course, the market hasn't been blind to these developments -- Fannie Mae's share price is more than 40% below its five-year high. While Warren Buffett's decision to sell the bulk of BerkshireHathaway's (NYSE:BRK-A) (NYSE:BRK-B) positions in Fannie Mae and Freddie Mac in 2000 now appears prescient, any stock can offer good value at the right price. Several well-respected value investors currently own Fannie Mae, including Wallace Weitz and David Dreman.

The Motley Fool's own value maven, Philip Durell, has selected Fannie Mae as one of his picks for Inside Value. If you wish to read his analysis and see his other picks, try a 30-day free trial to Inside Value.

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Fool contributor Alex Dumortier has no beneficial interest in any of the companies mentioned in this article. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.