By Katie Benner

The Bush administration has held talks about what to do if mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) fail, The Wall Street Journal reports Thursday, citing people familiar with the matter.

Even though the discussions have been ongoing for months and are described as part of the Treasury Department’s normal contingency planning, the newspaper says talks have become more serious as the stocks of both companies continue to fall. On Wednesday, shares hit their lowest closing prices in more than 15 years after plummeting Monday. Freddie and Fannie shares were down more than 19% and 10%, respectively, in afternoon trading Thursday.

Former St. Louis Federal Reserve president William Poole tells Bloomberg that the firms are already insolvent and may need a bailout. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-value accounting rules, Poole said.

“Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer,” Poole told Bloomberg.

These government-chartered, publicly-held companies are vital to the functioning of the housing market because they buy, package and guarantee a disproportionately large amount of the country’s mortgage debt. The Journal says the two companies own or guarantee about $5 trillion of mortgages, or nearly half of all U.S. home-mortgage debt outstanding. Serious problems at either firm could threaten the country’s chances for a housing recovery and economic comeback.

The Journal report was quick to point out that officials don’t expect either company to fail and that no rescue is imminent, but that Treasury officials are talking about what the government could do if Fannie and Freddie become so stressed that they can no longer borrow enough money to fund their operations.

Even if Fannie and Freddie stay afloat, common shareholders have lots of reason to worry. They could suffer even larger losses as housing prices continue to fall and mortgage defaults rise; and they will likely have to raise significant capital to make up for these losses. Bond investors are demanding higher interest rates for Fannie and Freddie bonds, evidence that the markets think they are becoming riskier investments.

If investors lost confidence in either company, the government would have to step in, Peter Wallison, a former Treasury Department general counsel, told the Journal. “The losses would extend through so much of our economy, and so much of the world economy. There is simply no way that the United States government can let it happen,” Wallison was quoted as saying.

Fannie and Freddie would not speak with the Journal about the government discussions.

If the firms ran into real trouble, they would most likely raise capital from private investors, even though that would dilute the interests of current shareholders, Josh Rosner, an analyst at Graham Fisher, said.

Freddie Mac (FRE) is trying some damage control. With a wave of foreclosures sweeping American neighborhoods, the government-backed mortgage investor is reaching out to struggling homeowners. The company recently posted a video on YouTube showing how to avoid foreclosure scams, the Washington Post reports. Freddie says it’s trying to flag schemes in which thugs lure borrowers to sign away their home equity.

The move comes as a difficult year at Freddie nears a close. The company’s shares have lost half their value in 2007, as the decline of the housing market has saddled the company with big losses on souring mortgages. Last week, CEO Richard Syron predicted Freddie will repeat its $2 billion third-quarter loss in the fourth quarter.

Billions of dollars in coming credit losses aside, however, the company’s future “looks better and better,” he told investors at a Goldman Sachs conference. Indeed, Freddie’s outlook is so glossy that this weekend the company sprang for what one correspondent terms “a decadent holiday party,” according to Barry Ritholtz. As if shareholders haven’t paid for enough Freddie follies already.