Stop trashing Ben Bernanke -- the looming failures of the two largest government-sponsored entities (GSEs), Fannie Mae and Freddie Mac, are bigger than anything we have seen before. In fact, Bernanke himself has been talking for years about the "widespread misperception by investors that the U.S. government would not allow a GSE to fail."

Congress and some investors were just not listening. Now is the time to ask, what if the debt and mortgage-backed securities of these firms are no longer investment grade?

Last year I wrote an



saying that


Chairman Bernanke was going around warning about a significant financial failure, one that could redefine the meaning of the words global financial crisis.

In March 2007, at the annual convention of the Independent Community Bankers of America in Honolulu, Bernanke clearly said that all financial crises 1.) involve the failure of a large entity and 2.) originate from failures of due diligence or discipline by market participants. He clearly spelled out a case against the preferential financing incentives for Fannie and Freddie that allowed them to acquire and increase the size of their portfolios. He clearly pointed to what some call the elephant in the room: the GSE mortgage portfolios.

So what's Bernanke's problem with these two government-sponsored entities?

Bernanke's gripes are fairly basic. The combined outstanding debt and mortgage-backed securities (MBS) obligations of the two companies exceeded $5.2 trillion in 2007, more than the $4.9 trillion of public government debt at the time. The effect, again according to Bernanke, is that Freddie Mac and Fannie Mae are undercapitalized entities that, unlike banks, will not protect investors.

Not Just Stock

Don't assume that this just means the equity. These are Bernanke's words, "Only if GSE debt holders are persuaded that the failure of a GSE will subject them to losses will they have an incentive to exert market discipline." In other words, debt investors must also bear the burden of a restructuring when it occurs.

Those were kind words. These warnings were made from tropical Hawaii, before the Dow reached its 14,000 peak. This was before the post-Bear Stearns tsunami. That bailout washed away many investors on both the debt and equity side. Since then, the Fed has clearly demonstrated its focus on using liquidity as a means of handling financial system risks.

When I wrote that article last year, Fannie Mae shares were trading at $54. On Monday the shares closed at $9.73, and they are likely to fall further.

At that time, I -- like most of my former colleagues at the rating agencies where I started my career 25 years ago -- believed the government would be a more significant factor in helping re-capitalize these public companies.

Recent announcements that the government would consider adding to Fannie and Freddie's capital are actually


negatives. It implies that unlike other recent financial entities that these two are in need of immediate capital not readily found elsewhere. And the shockingly small size of the government's investment indicates either an unwillingness to act or a true misunderstanding of how serious the shortage is.

A Small Fix Won't Help

Don't expect a measly couple billion dollar investment in these GSEs to stop the capital drain and damage to these companies. Since November of 2007, Fannie Mae has raised $14 billion in new capital. Last week, Freddie Mac claimed that its portfolio runoff and a dividend cut could bring it $3 billion in a year. In fact, given the magnitude of the problem, nothing less than a full takeover of Freddie Mac and Fannie Mae will stem the tide. That would be a big leap for a government that, according to Government Accounting Office estimates, will run a deficit of over $400 billion for this year.

If the U.S. government assumes responsibility for Fannie and Freddie's $5 trillion in mortgages, including the hundreds of billions that are going sour, what's going to happen to the credit of the U.S. Treasury?

From a rating perspective, a couple of billion in the bank as capital is not real support. If Freddie Mac and Fannie Mae were smaller corporate entities, they would have already been downgraded by the agencies. The smart thing for the rating agencies to do is put these two U.S. government-sponsored entities on credit watch with negative implications.

In the past, the agencies have been willing to take on municipalities and other governments, forcing them to recast priorities and really restructure. Doing this for the two GSEs would send a clear signal to all investors that these are not risk-free enterprises. The rating agencies still have a chance to make a difference for debt and GSE holders, but don't hold your breath waiting for this.

A Likely Outcome

It's more likely that foreign institutional investors react first by requiring much higher yields from these issuers. Higher interest rates for these two GSEs spell more trouble for the mortgage and debt markets, since these are the benchmark companies used to set lending rates against. The outcome of this will be higher levels of interest rates across the government and corporate spectrum.

But higher interest rates are just the tip of the iceberg. What will make this failure such a big deal is that this current fiasco is a carry-over from the old savings and loan mess from the 1980s. While the government did a lot to get that behind us, it did one thing we still have not paid for. It issued new capital to banks and thrifts via Fannie Mae and Freddie Mac guarantees. With the Fannie Mae guarantees, the banks could then show better capital ratios and also earn fees on the volume of mortgages originated. It created instant solvency for other companies on the basis of perceived credit worthiness from an implied government guarantee.

This problem has the potential to cascade across the financial sector and dwarf the subprime issues. It will definitely affect U.S. financial institutions that will see the market value of these holdings decline from interest rate and credit spread deterioration. These firms will be doubly damaged if they invested their surplus in Fannie Mae or Freddie Mac securities that once were considered safe.

As this crisis unfolds, it will be very clear to all that it was a huge mistake to assume that the government would step in and protect investors. That's not their mandate.

So whose job is it to tell the world that this GSEs' support system is broken? Theoretically, the rating agencies should have pulled the power on the runaway mortgage train. Just imagine what would happen if overnight one of the rating agencies really decided to downgrade Fannie Mae or Freddie Mac debt in response to credit deterioration.

Unfortunately, Bernanke was right. The Fannie and Freddie failures will be remembered for all time as the ones that started the U.S. market downturn. Too bad the rating agencies appear to have missed this one.

Rudy Martin is the former director of research for Ratings. Earlier he worked 25 years in investment research and management positions with Fidelity Investments, Lincoln National, Dean Witter Reynolds and Transamerica Investments. He began his career as a securities investment analyst at Duff and Phelps where he published equity and fixed income securities investment recommendations. Martin holds a master's degree in finance from Kellogg Northwestern University.