The dike might be cracking on the U.S. financial system and U.S. regulators are trying to figure out how to make sure it doesn't burst.

Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), the behemoth caretakers of U.S. home ownership financing, are looking increasingly unstable. Their demise would spell disaster, and the U.S. cannot allow that to happen.

The market went nuts this week as former St. Louis Fed President Albert Poole suggested that Freddie Mac is technically insolvent. What does the market think? As of Friday morning, Fannie and Freddie stock were down 53% and 64%, respectively ... just this week! I think the market has weighed in with an opinion.

Why are the stocks nose-diving?
Investors are wary of the mortgage lenders for two main reasons. First, falling housing prices and rising mortgage defaults are expected to result in massive losses. This is combined with some of the subprime infection on their balance sheets similar to what Merrill Lynch (NYSE:MER), Citigroup (NYSE:C), and UBS (NYSE:UBS) are experiencing. Second, the losses may require them to raise capital ... and that could massively dilute shareholdings.

Not only are the stocks of the two lenders getting hammered, but the bonds are also taking a big hit. Although Fannie enjoys an implied government guarantee and a AAA rating, lenders are demanding higher rates. Fannie issued $3 billion in two-year bonds this week at a spread of 0.74% above the Treasury rate. This spread is almost triple the difference of two years ago and double that of one year ago.

How bad is it?
Poole said that Freddie currently has more liabilities than assets. By standard accounting principles, this makes it insolvent. Many believe that Fannie will be in the same boat very shortly. If the mortgage lenders cannot raise sufficient capital to cover their balance sheet losses, they could fail.

According to The Wall Street Journal, the Bush administration has held ongoing meetings with regulators concerning possible actions if the massive mortgage lenders fail. 

How bad could it get?
What would happen if Fannie and Freddie were to fail? The housing market simply could not function without them. Consider this: The mortgage lenders guarantee or own one-half of all U.S. mortgage loans, or about $5 trillion worth. The ramifications on the U.S. and world economy would be catastrophic.

The government simply cannot let them fail. If push comes to shove, how can they be saved? The government could bail them out by having the Federal Reserve purchase mortgage assets in exchange for liquid Treasuries, or the U.S. government could simply guarantee the mortgage lenders' obligations. Either way comes down to a government or taxpayer bailout, perhaps a massive one ... the companies have an estimated $1.5 trillion in debt.

Foolish bottom line
Fannie and Freddie will most likely be able to raise capital and take care of themselves. The government doesn't expect them to fail. Government authorities are just planning prudently. But, if the lenders can't raise sufficient capital, the taxpayers will simply have to bail them out, no matter what it costs. The repercussions of not doing so would be unthinkable.

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