The banking system has been crumbling for over a year, but last month's collapse of American International Group (NYSE: AIG) -- which prompted an $85 billion government takeover -- suggests that insurance is not immune from the problems. As a reminder, AIG got snared in the $62 trillion Credit Default Swap (CDS) market whose growth was spurred by McCain advisor, Phil "Americans are Whiners" Gramm.

And as insurance crumbles, banks keep suffering. Bank of America (NYSE: BAC) and National City Corp. (NYSE: NCC) are both hurting. How much?

• Bank of America's earnings plunged 68% to $1.18 billion, or $0.15/share -- missing by 60% analysts' forecast of 62 cents. Bank of America will raise capital by selling $10 billion of common stock and slashing its dividend in half from 64 cents to 32 cents. One analyst cut the bank's 2009 earnings estimate to $2.50 per share from $3 per share -- this is well below the $3.12 per share from a Thomson Reuters analyst poll -- and lowered his price target by $2 to $26.

• National City Corp. and its National City Bank both suffered debt downgrades from Fitch. For instance, Fitch slashed the bank subsidiary's long and short-term Issuer Default Ratings (IDR) to A- from A. And it lowered the bank and holding company's Individual rating to C from B.

I am not sure that Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) will make it through the month as public companies. Barron's quoted an anonymous senior official -- who sounds an awful lot like Hank Paulson to me -- that unless Fannie and Freddie could raise at least $10 billion each, the government would bail them out while wiping out common shareholders and eliminating the preferred dividend. Since then, investors have been dumping shares of Fannie and Freddie like there's no tomorrow.

Who wins and who loses if Fannie and Freddie's shareholders are wiped out? As I said on CNBC's Power Lunch this afternoon, the winners are investors who shorted Fannie and Freddie years ago and are now reaping enormous profits. I also think that some Wall Street investment banks will win big as they get the job of selling off Fannie and Freddie's pieces. The losers are their biggest common and preferred shareholders -- including some well known mutual funds.

The winners are:

• Jim Rogers, Rogers Holdings - Rogers originally shorted Freddie and Fannie in March 2006 and appeared on Bloomberg on November 20, 2007 to discuss why he did it and where he thought their stocks would go.
• Doug Noland, Prudent Bear - As I posted, since the late 1990s, Noland's research has concluded that Freddie and Fannie would "shudder" when the US credit bubble eventually burst. Noland has profited from the short bets he made -- but he says it is emotionally painful to watch them fail.

The Associated Press reports that the House passed a bill that will increase the amount of debt available to buy houses. In the process, it will make the U.S. a much riskier place to invest. That's because when a country's debt tops 60% of its Gross Domestic Product (GDP), lenders consider it a risky credit. The House bill will lift the U.S.'s ratio to 75%. And the dollar will continue to plummet.

Of course, the bill is not being sold that way. Instead its stated goals are to help 400,000 people with foreclosures and to save Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). Here are six key provisions according to AP:

• Puts distressed real estate on the government's books - Provides $3.9 billion in grants for "devastated neighborhoods" -- a provision the White House hated since it looked like the S&L bailout's RTC, that Bush I approved.
• Gives Paulson unlimited Fannie/Freddie bailout power - Gives the Treasury Department an unlimited line of credit to bail out Fannie and Freddie and to buy an unspecified amount of their stock.
• Creates new debt for drowning borrowers - Lets 400,000 foreclosing homeowners refinance into more affordable, fixed-rate loans backed by the Federal Housing Administration (FHA).

The New York Times reports that the cost to bailout Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) could hit $25 billion. But that cost dwarfs what the collapse of the real estate market might cost our country in total. I think $8 trillion is a reasonable estimate -- that's about 56% of our $14.2 trillion Gross Domestic Product (GDP).

Why are we talking about a taxpayer bailout of these two government sponsored entities (GSEs)? After all, shareholders own them but there's some vague notion that since they're GSEs, government should bailout the investors who bought their $5.2 trillion worth of mortgage-backed securities (MBSs).

So how did the government pick the $25 billion figure? It turns out that the Congressional Budget Office (CBO) doesn't know how much the bailout will cost. So it is developing different scenarios. One suggests that a bailout will cost nothing. Another suggests that there's a 5% chance that the bailout will cost $100 billion. I think this means that the bailout has an expected value of $5 billion (the chance of the scenario times its cost). Regardless, the CBO's $25 billion looks like it will be joined by an estimate that follows the Fed and OCC's look at the books of Fannie and Freddie.

Reuters reports that Fed Chair Ben Bernanke met yesterday with Freddie Mac (NYSE: FRE) chair Richard Syron and told him that Freddie and Fannie Mae (NYSE: FNM) would get access to the Fed's emergency discount window. (For those who are new to these two companies, the New York Times has a helpful graphic that helps explain them.) This is what he did to the entire investment banking industry earlier this year when Bear Stearns was headed south.

Now that Freddie and Fannie are free-falling, helicopter Ben is preparing to open the discount window to them as well. This means that these two government-sponsored packagers of mortgage-backed securities will get access to taxpayer's capital instead of going through the arduous process of trying to raise capital from private investors.

I wish I could get the Fed to bail me out when I make bad investments. This is what it means to be too big to fail. But since the Fed will not confirm the Reuters report, we will need to wait to see whether this report is true. Freddie was down 3% during regular market hours -- it had been down as much as 50% during the day. Fannie tumbled 26% during regular hours. Its stock had also been sliced in half earlier today.

Welcome to the new and less profitable world of lending. Countrywide Financial's (NYSE: CFC) September lending dropped 44% to $21 billion which helps explain why it announced plans to cut its workforce by 12,000 jobs, or 20% of its workforce, according to a report in today's Wall Street Journal.

Not only are there fewer loans, but the type of loans Countrywide is making now and selling offers lower gains. Countrywide no longer makes the riskier loans that were so profitable because they can't find investors to buy them. New loans now being made are the type that can be sold to government-sponsored investors Freddie Mac or Fannie Mae or loans Countrywide wants to hold itself for the long haul.

Bruce Harting of Lehman Brothers estimates that the gain Countrywide made on these safer bets is about 0.48%, while those riskier loans generated an average gain of 1.09%. That difference is going to hit Countrywide's bottom line hard. Lehman Brothers told the Journal it expects Countrywide to show a third-quarter loss of 95 cents a share or $618 million. Moshe Orenbuch, an analyst at Credit Suisse, expects the loss of $1.3 billion loss or $2.17 a share.

Don't know whose right and Countrywide is staying mum on the issue until it reports earnings on October 26. Stay turned for follow-up, but don't expect any good news out of Countrywide.