Markets will open tomorrow with news that the federal government has effectively taken over both Fannie Mae and Freddie Mac, and extended a lifeline as well to the Federal Home Loan Banks.

The U.S. Treasury Department, through its secretary Henry Paulson, describes its rescue plan as “not a nationalization”, but let’s not be fooled here. The federal government is substantially widening its line of credit to both Fannie Mae and Freddie Mac, it is injecting $15 billion of new equity into the companies, and the Federal Reserve has opened the discount window to both agencies so that they can borrow at the 2.5% overnight rate.

Anytime the federal government buys shares in a company, even if it is a special type of new share created for this purpose, that company has been nationalized. The board of directors and management of the company have lost control, and in this case the Federal Reserve has been given new powers of oversight over the agencies, in yet another expansion of Fed regulatory control.

This is a very similar package to the rescue of Bear Stearns, only the white knight buying the distressed financial companies is the federal government. As with Bear Stearns, all of last week’s assurances by the government that Fannie Mae and Freddie Mac were well-capitalized and safe have proven to be ludicrously false. Obviously the companies are insolvent if the government has to go to such lengths to shore them up.

Different markets will take this news in different ways. The foreign exchange markets bid the dollar up on the premise that a crisis has been avoided. The U.S. stock markets may also react positively for the same reason, because these markets have been heavily oversold for at least a week and are due for a two to four week recovery anyway.

The stock in both companies may have an uncertain and volatile reaction, since on the one hand the companies will not be going bankrupt (which is positive), but on the other hand the existing shareholders have just been heavily diluted and effectively had their shares devalued.

The bond market for U.S. Treasuries may also have a mixed reaction. In the short term, the aversion of a crisis may be positive, but in the long term there is great uncertainty about the amount of agency debt that the U.S. Treasury will now be owning or guaranteeing. No one knows what the ultimate losses will be to the taxpayers, but these two agencies support about half of the $12 trillion in outstanding mortgages. It is not unreasonable to expect at least 5% of outstanding mortgages to enter foreclosure, judging by the current rates of failure, and that would mean $600 billion in new federal government debt added overnight. From a practical standpoint, this process will begin immediately, because both agencies can trade in mortgage securities at the Fed for U.S. Treasuries.

The Fed continues in its path of becoming the sinkhole for unwanted mortgage securities in the U.S., and increasing amounts of its balance sheet are being consumed by such securities, which can range from high quality to dodgy. There comes a point here where the markets start wondering about the deteriorating credit quality of the Treasury and the Fed themselves. The ratings agencies of Moody’s and Standard & Poors will no doubt reaffirm the Aaa status of U.S. debt after this episode, but their credibility is not very high, and even they will admit they do not know how much foreclosure losses will ultimately be experienced in the U.S.

That is, of course, the ultimate question here. We are coming up on the one year anniversary of this credit crisis, and we have come a very long way. Last August, only a handful of us were predicting the collapse of Fannie Mae and Freddie Mac, and we were out on the doom and gloom branch of economic and market forecasting. Back then, for an overwhelming number of market participants and observers, what has occurred this week would have been unthinkable.

Now that it has happened, you will hear a lot about bullets being dodged, and the government being on top of things and managing the crisis. But this time the reaction will be a little bit different; having faced up to the unthinkable, there will be wonderment as to what other unthinkable things might next occur. The doom and gloom crowd, while not necessarily being given credit for being right (Cassandras are normally shunned), will at least be listened to more carefully.

And here is what they will say. The foreclosure process is by now means over. The rate of increase in foreclosures might slow down, but there is much more pain to come for homeowners and banks. Nothing is working right in this foreclosure crisis, especially the part where homeowners are supposed to be given breaks. What we are learning is that the banks do not have the staff to deal with the overwhelming volume of requests for help from homeowners, and even if they did, the staff have no incentive to help. Mortgage servicers have one primary duty: to squeeze out as much income for the investors who bought the mortgages as possible. That incentive worked wonderfully when home values were going up and the market was expanding, but it is utterly disastrous now that the market is going down.

The death spiral we are in - where banks dump foreclosed homes on the market at give-away prices, lowering home values in communities all across the nation, leading to many more homeowners being underwater in their mortgages, giving yet more incentive to such homeowners unable to meet payments to turn their keys over to the banks, and thus ultimately pushing the banks into dumping yet more foreclosed homes on the market – will continue until values get back to the historic normal growth rate of 2% a year in home value. This means prices nationally have at least 20% more to decline on average.

We already saw bond prices sink Friday in reaction to the agency debt crisis, and this “rescue” may ultimately push prices much lower. This means Treasury yields will head up, and mortgage rates will head higher still. Even if Fannie Mae and Freddie Mac are still around to support the market, albeit in crippled form, declining home values and increasing mortgage rates are a deadly combination that will all but shut down the mortgage market.

The recession will deepen, jobs will be cut, and consumer spending will falter, even if oil prices come down (not a certainty by any means). So here is another doom and gloom scenario to worry about: defaults will skyrocket on second mortgages, home equity lines of credit, commercial real estate loans, auto loans, revolving credit, and credit card balances. As this occurs, U.S. banks will be put under unbearable pressure, and failures of well known names will occur. More unthinkable things will occur, until the banking system is purged of bad debts and becomes unrecognizable from today. This may take at least five years to play out.

The parallel banking system that was used to leverage up borrowing for twenty years has already disappeared, and when the banks themselves stop lending, we will live in a strange world where no one will be able to borrow – a 1930s, depressionary world. Unthinkable, but now probable.

Finally, as this world unfolds, the ability of the federal government to keep pulling rescues out of the hat will disappear. There aren’t too many strong banks left to take over weak banks, and the federal government not only has lost credibility in these crises, it is progressively losing its credit-worthiness. Ultimately, the Aaa rating of the U.S. will disappear, along with its privilege as the reserve currency provider for the world. The U.S. will not sink into oblivion like the Soviet Union did, but five or ten years from now visitors to the U.S. will remark how much the country reminds them of the third world.