SERIOUS MONEY:THE beleagured United States financial system resembles a drunk stumbling from one trauma to the next, with the sense of despair increasing with each eruption.

The virus that broke out in the subprime segment of the mortgage market last summer has become the worst credit crisis in modern history, with the casualty list including 260 mortgage lenders and more than 80 hedge funds so far, not to mention Bear Stearns, the 85-year-old "Sparta of Wall Street".

The epicentre shifted last week to Fannie Mae and Freddie Mac, which combined own or guarantee almost half of the $11 trillion (€6.9 trillion) in outstanding mortgage debt.

The share prices of the so-called ugly sisters plummeted to their lowest levels in 17 years last week as concerns that they were both on the brink reached fever pitch. Both Fannie and its younger sibling released statements saying they were in good financial health but the capital markets thought otherwise and the ailing companies were checked into rehab on Sunday evening.

But who are the ugly sisters? Fannie and Freddie are shareholder-owned companies created by the US Congress to develop a liquid national market for residential mortgages in order to promote home ownership.

They raise capital by issuing debt securities in the world's capital markets and use the funds to purchase home loans from mortgage originators, which enables the private lenders to make new loans. The home loans are then packaged into residential mortgage-backed securities, which are sold to investors with a credit guarantee.

The ugly sisters benefit from the low cost of funds vis-a-vis private mortgage lenders, which arises from the perception that they are low-risk borrowers.

It is widely believed that the US government will bail out the ugly sisters if they become insolvent even though their debt securities contain a disclaimer that they are "not guaranteed by the United States and do not constitute a debt or obligation of the United States".

This belief has contributed to significant purchases by insurance companies and pension funds, not to mention the central banks of China, Japan and Russia.

The implicit guarantee has come to the fore in recent months as the worst housing recession since the 1930s led to heavy losses and a substantial deterioration in their balance sheets. Combined losses in the nine months to March 31st exceeded $11 billion and reduced their capital bases to razor-thin levels.

The ugly sisters' shocking performance in recent quarters has occurred despite the fact that they were relative bystanders to the subprime frenzy and focus mostly on prime mortgages. This is indicative of the perilous state of the US housing market.

Fannie and Freddie's share prices lost roughly two-thirds of their value from the eruption of the subprime crisis last summer to the collapse of Bear Stearns in the spring and plummeted to new depths last week as William Poole, former president of the Federal Reserve Bank of St Louis, highlighted what was clear from their accounting statements months ago: Freddie is technically insolvent and Fannie is not far behind.

Given that house prices have exhibited an accelerating pace of decline in recent months, while delinquencies and foreclosure rates continue to rise in the face of rising unemployment, it is hard not to come to anything but the conclusion that the ugly sisters are on the edge.

The inevitable followed at the weekend as US treasury secretary Henry "Hank" Paulson promised that the government and the Federal Reserve would each extend credit to prevent a liquidity crisis at Fannie and Freddie.

His statement made explicit what had previously only been an implicit government guarantee behind the $5.2 trillion of mortgage debt insured by the two companies. This was never in doubt as their failure would cause the secondary market to freeze and deal a shattering blow to the already reeling housing market.

Indeed, Fannie and Freddie have single-handedly kept the secondary market alive for some time, with the value of their mortgage assets increasing by $500 billion since last summer compared to a decline of $150 billion at private lenders.

Paulson's words will almost certainly have to be followed by action as the housing market shows no sign of bottoming while vacancy rates are at the highest levels since the 1930s and continue to rise. Roughly 19 million of the 130 million housing units in the US are empty and it could take years for inventories to return to normal.

Despite the assurances from Paulson, this saga is far from over.

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