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.

After last Thursday, when the Dow lost 345 points, I speculated that another bailout plan would emerge over the upcoming weekend. As I posted, there was no obvious reason why the market fell so much that day. But one of the possible clues of trouble was that Bill Gross, who manages the $800 billion Pacific Investment Management Co. (PIMCO), was making noises about how the government needed to spend $500 billion to save the housing market.

Coincidentally, Gross -- whose holdings include $500 billion in mortgage-backed securities (MBS) -- is rumored to have "helped" the Treasury with its bailout plan for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). And he has profited handsomely from it since he bought the MBS during the panic-- which have risen in value post-bailout.

The reason I felt that a bailout was coming is because this administration has a solid track record of responding to stock market plunges with weekend rescue plans. Evidently it is concerned that Asian markets -- more specifically China's which happens to own $340 billion worth of MBS -- need a weekend bailout plan so when their markets open on Monday they will have something to celebrate. The Big Picture has provided a helpful service by listing the six Sundays in the last 14 months that the government has announced a new bailout plan for the financial markets.

Three weeks after Barron's reported that a senior administration official -- my guess is it was Hank Paulson -- leaked details of a "rescue" plan for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) -- Bloomberg News reports that its implementation could be imminent. And in after-hours, shares of both companies are down 20%. If what Barron's reported -- wiping out common shareholders and slashing preferred dividends -- proves prescient, both stocks have further to tumble -- as in all the way to 0.

Bloomberg reports that Paulson met with Ben Bernanke and the CEOs of Fannie and Freddie and the head of the Federal Housing Finance Agency which oversees the two. And they have catering set for the entire weekend. I wonder what they are serving? I think PIMCO bond guru Bill Gross knows. He said, "There's probably a 95 percent chance that the moment that something will happen is Sunday or Saturday," according to Bloomberg.

Yesterday Gross called for the government to use $500 billion to bail out the real estate market. As I posted yesterday, this bailout is for the benefit of people like Gross and China's central bank which owns $340 billion worth of Fannie and Freddie mortgage-backed securities. If you happen to be among the holders of their common or preferred stock -- you are going to lose it all. As I suggested this morning, after the market lost 345 points yesterday, the government needed to announce another rescue plan by Sunday night.

Our government has been doing its share of bailouts in the last year. It put $29 billion of taxpayer money at risk to finance the takeover of Bear Stearns. It stands ready to use $800 billion to bailout Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). And now General Motors (NYSE: GM) wants $50 billion in government guarantees to finance fuel efficient cars. I have been looking into the bailout issue and whether it is beneficial or a misuse of funds - and there is a lot of debate about this issue. These bailouts may make political sense but are they in the long-term economic interests of the country?

A colleague of mine who was a Budget and Cost Analyst for a top government agency has been thinking about the political aspect of bailouts and shared his thoughts with me. As he wrote, "It is a sure thing that either party could get votes from a bailout, but they might loose some as well. Where a party could really improve its position would be to support a bailout, but lose."

He suggests that this outcome would pay off in the short-run but could damage long-term economic outcomes. As he suggested, If the party supported a bailout but lost, "it could claim that it was trying to support the victims, but had been frustrated by the other party. And this could be used to promote the party for many years in efforts to get votes. While maneuvers of this sort may get short run votes, over the long term they might be hurtful of sound economic growth and performance."

It's not clear how big the bailout of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) will be but it is becoming clearer who it is for. Yesterday, I appeared on CNBC's Power Lunch to discuss the winners and losers from the collapse in their common and preferred equity. But today, Bloomberg News reports that one of the biggest beneficiaries of the bailout will be the government of China.

In addition to buying most of our consumer goods from China, our government could use as much as $800 billion of our tax dollars to assure that China and other holders of Fannie and Freddie assets don't suffer any losses. Bloomberg interviews Yu Yongding, a former adviser to China's central bank who said, "If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it is not the end of the world, it is the end of the current international financial system."

That sounds like a pretty strong statement to me. I am not sure why Yu made it or what it means. So I will throw in a mixture of fact and fiction to offer my interpretation. Bloomberg reports that China holds $376 billion worth of "long-term U.S. agency debt [which] is mostly in Fannie and Freddie assets." CLSA estimates that the six biggest Chinese banks hold $30 billion worth of such paper, according to Bloomberg. Those are the facts, now comes the fiction part.

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 New York Times reports that Freddie Mac (NYSE: FRE) CEO Richard Syron ignored warnings four years ago that Freddie was taking on too much risk by underwriting poor quality mortgages and that its capital base was too thin. Last week, the President signed a bailout bill that increases the national debt limit by $800 billion -- the potential size of the bailout of Fannie Mae (NYSE: FNM) and Freddie.

If the sources that the Times is quoting are right, the blame for Freddie's portion of that bailout rests with Syron. It interviewed Freddie Mac's former chief risk officer, David A. Andrukonis, who warned Syron that it was underwriting bad mortgages. According to the Times, Andrukonis "recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that "would likely pose an enormous financial and reputational risk to the company and the country."

Syron claims that he received enormous pressure from an un-named lawmaker pushing Freddie to take on the bad loans. So the Times reports that as Syron and others sat in a conference room reviewing the memo, Syron "refused to consider possibilities for reducing Freddie Mac's risks. He said we couldn't afford to say no to anyone."

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.

MAJOR PAPERS:

• The Wall Street Journal reported that it is the Bush Administration versus Democrats versus Republicans to decide the strategy to stabilize Federal National Mortgage Association (NYSE: FNM) -- Fannie Mae -- and Federal Home Loan Mortgage Corporation (NYSE: FRE) -- Freddie Mac. The Administration's plan would let the Treasury Department advance a credit line and the opportunity for the government to buy equity in either firm. A package is expected to pass but not before the political and economic ramifications are battled out. Democrats and Treasury want it to be a part of a housing rescue plan; Republications oppose it.
• The Clinton Foundation, headed by former President Clinton, believes it has a pricing agreement in place that it expects will make malaria drugs affordable and available to millions of poor people worldwide, the Wall Street Journal reported.
• The Financial Times reported that UBS AG (NYSE: UBS) and Liechtenstein's LGT Group will today be accused by U.S. Congressional investigators of using the "cloak of bank secrecy laws" to help American clients evade billions of dollars in taxes.

• Globes reported that Teva Pharmaceutical Industries Limited (NASDAQ: TEVA) is talks to acquire Barr Pharmaceuticals Inc (NYSE: BRL). The price tag is said to be between $7B and $7.5B.

The New York Times reports that the Securities and Exchange Commission (SEC) is going to begin examining "rumor-spreading intended to manipulate stock prices." Rather than protecting investors against false statements from financial advisers, as happened in the case of the $330 billion now-frozen Auction Rate Securities (ARS) market, the SEC is out to protect executives of companies they run into the ground.

What does the SEC's new policy entail? The Times says that the SEC will start today by focusing on "what policies brokerage firms have in place to prevent the passing of false information. The intent is to stop malicious rumors without hampering the natural exchange of information in the marketplace." I am not a lawyer but it sounds like the SEC will have a tough time monitoring all the exchanges of information among those on Wall Street unless it plans to record every cell phone, land-line, e-mail, IM, and Blackberry exchange all around the world.

Meanwhile, it seems that the government has strained to distinguish between fact and fiction when it makes big policy decisions. For instance, last year Hank Paulson and Ben Bernanke were saying that the subprime problem was "contained." Would the SEC indict Paulson and Bernanke for spreading false rumors intended to manipulate stock prices? After all, their statements -- which are clearly false -- may have had the effect of causing investors to buy stock in non-subprime mortgage lenders. Could they get off the SEC's hook by proving they had no intent to manipulate stock prices?

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.

Just like on September 11, 2001, the beautiful weather in the Northeast is being paired today with a catastrophe. But today's catastrophe will result in people losing money, rather than their lives. Those who will lose money -- and already have lost plenty -- are the people who own shares of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) and the $5.2 trillion worth of mortgage-backed securities which these two guarantee.

But not everyone is losing money. The New York Times reports that one short-seller is profiting hugely from the rapid decline in these two stocks. In particular, Douglas Noland, a portfolio manager at the Prudent Bear Funds, was willing to go on the record. The Times reports that since the late 1990s, Noland's research has concluded that Freddie and Fannie would shudder when the US credit bubble eventually burst.

But there's no joy in Noland's heart even as his investors profit. According to The Times as he watched Fannie and Freddie fall 12.7% and 21%, respectively, on Thursday, Noland said "I am sickened by this. I had the same sick feeling after September 11. These companies are at the heart of the United States financial system of dollar based securities. Millions of people will suffer."

The New York Times reports that global stock markets are tumbling. Nobody really knows why but the latest theory is that investors are concerned about the capital problems at Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) about which I posted yesterday.

Here's a survey of some of the global market damage:

• Nikkei 225 stock average fell 2.5%
• The Hang Seng index in Hong Kong down 3.3%
• S&P/ASX 200 index in Sydney declined 1.4%
• In London morning trading, the FTSE 100 index was down 2.7%
• DJ Euro Stoxx 50 index, of euro zone blue chips, fell 2.3%
• DAX in Frankfurt fell 2.4%
• CAC 40 in Paris sank 2.4%

Bloomberg News reports that Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) are down significantly and their credit default swaps are up. What gives? Rumors abound that these two government-sponsored mortgage bundlers will need to raise $75 billion as they take write-downs.

Thanks to a new accounting rule -- FAS 140 that seeks to stop companies keeping assets in off-balance sheet entities -- Fannie and Freddie may need to bring mortgages back onto their books, requiring them to put up capital. Fannie has raised $6 billion in capital to offset writedowns and Freddie raised $13.5 billion since December and said last week that it plans to raise $5.5 billion more.

But these stocks have not done so well this year. Today's declines extend Fannie's 2007 drop to 62% and Freddie's to 66%. I am not surprised that those fears are out there. I posted that these two could be the subject of a $1 trillion government bailout. So a $75 billion capital infusion sounds like chump change compared to the bailout. I am a bit surprised that this comes as a surprise to investors. But I would not be trying to catch these falling knives either.

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