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.

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.

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).

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.