Fannie/Freddie bailout background: How we got in this mess

Now that we know Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) are likely to cost taxpayers as much as $800 billion in a government bailout, I thought I'd provide some background on how we ended up in this mess. Here goes:

Fannie and Freddie buy mortgages, bundle them together, guarantee the payments, and sell them to investors. Between the two of them, they control 43% of the $12 trillion mortgage market -- or $5.2 trillion worth of mortgage-backed securities.

In the last year, with housing prices in free fall and foreclosures spiking, they've lost $14.9 billion between them -- about 0.3% of those assets. And at the end of June, they held $84 billion in capital -- $12 billion more than the $72 billion regulators require, according to Bloomberg News. Do these conditions warrant radical government action?

The government thinks that they do. As I posted, yesterday, Treasury Secretary Hank Paulson is likely to announce a plan to put Fannie and Freddie into conservatorship. The government will run them and will wipe out the value of the common shares and slash the value of their preferred stock.

Plus, it will dismiss the executives and board members of both firms while doling out as much as $800 billion -- spread out in chunks to be determined each quarter based on what the government thinks Fannie and Freddie need to keep functioning.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.