BACKGROUND
The book, "The Lost Scrolls: Fire", tells the story of the Fire Sages, how they were the Fire Nation's governing council until the Fire Lord (or head sage), so called that because he was the most powerful firebender and the most spiritually connected to fire, broke from them and took the rulership with him. The sages we see in Winter Solstice, Part 2, The Avatar And the Fire Lord, and the series finale are a dying breed, relics of an earlier time, who's only purpose now is to babysit Roku's temple and feed the Fire Lord information about the Avatar, or advise the Fire Lord in spiritual matters (and guard the secrets held in the Dragon Bone catacombs, apparently).
Everything under the cut has been manufactured as part of my own world-building for an AU fic.
I decided that, originally, the council would have thirteen sages. No reason, I just like the number thirteen. The head sage (the Fire Lord) had produced five powerful firebenders and decided it was time for his family of prodigious firebenders to take control of the council and declare themselves the supreme rulers of the Fire Nation. The head sage was a ruthless man who had raised ruthless children. The other sages were completely unprepared for their brutality. So his family's claim went largely unchallenged. It helped that some of the sages were promised incentives for not challenging him. And so the modern Fire Nation and the 12 Houses were born.
The first ruling Fire Lord ranked the other twelve sages based on their value to him. So the #2 sage was more powerful and influencial then #3, and so on, because the Fire Lord "said so". #12 was the least valuable / had the least to offer the Fire Lord. #13 was killed off along with his entire bloodline because he insolently dared to challenge the Fire Lord's claim of rulership.
The Fire Lord declared his family the 1st House, and ordered that the rulership of the Fire Nation be passed down exclusively through his descendants since they would always be the strongest firebenders and have earned the "divine right to rule" for this very reason. Every other sage was declared Head of Household for their respective families and given titles like Sage of the 2nd House, Sage of the 3rd House, and so on.. This was to make the "pecking order" clear: These sages were no longer equals. This also created a nobility more to his liking by trumping the previous nobility of land owners by making them a lower class than his elite sage team of insanely skilled Firebenders.
The eleven sages were ordered to advise and serve the Fire Lord as his "cabinet" or face certain consequences. Over the centuries, the Fire Lords had chiseled away at their cabinet's power and influence, abolishing the cabinet altogether and bringing in advisers outside of the 12 Houses to advise them as they saw fit. Commoners like Piandao and Shinu were allowed to hold seats in the Fire Lord's war room and were welcome at Court, honors which, just a few decades earlier, were only reserved for the nobility.
As the prestige of being a Fire Sage tarnished, and their power dwindled, all twelve Houses stopped supporting members who would want to follow that path. If one aspired to become a Fire Sage, fine, but being a Fire Sage did nothing to advance that House in any meaningful way, so one would be wasting their time. Ironically, in Aang's time, none of the current Fire Sages can trace their lineages back to any of the noble houses.
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THE FIVE MOST POWERFUL HOUSES
Each of the 12 Houses work to distinguish themselves from the other Houses. It's all about profile and getting noticed and finding a niche that your family can control.
The 1st House is the Fire Lord's House. They distinguish themselves by being the ruling family. They are a small House, having only four members: Ozai, Iroh, Zuko, and Azula. The Fire Sages and advisers have encouraged both Ozai and Iroh to remarry and grow their House by having many more children. This is especially true for Ozai since he is the Fire Lord and also still quite young. but Ozai has grown to despise the idea of remarrying because his first marriage was horrible. Ursa has made him hate and mistrust women which is why he has been molding Azula in his own image. Iroh has cut all ties from Ozai and Azula and hopes the 1st House collapses under the weight of it's own hubris now that Zuko has been banished from it.
The 2nd House distinguishes itself through it's political practices. They are the second largest house, comprised of nearly four hundred members. The 2nd Matriarch runs the House like a mafia Don. They are suspected to be involved in organized crime, and their brutality is legendary. They routinely challenge people to agni kais over fairly trivial matters. But their public profile shows them as being in loyal service to the Fire Lord at the highest levels of government -- judges, governors, mayors, one of Ozai's chief advisers, and so on... Many feel that they are also the Fire Lord's private enforces since this house boasts many skilled mercenaries.
The 3rd House is a House of soldiers, police officers, and martial fighting / bending instructors. They are descendants of the 3rd Sage and his wife, a warrior from an ancient clan of warrior women who protected the motherland from potential invaders during ancient times when pirates would attack their shores, before they had a modern navy. This House is comprised of some of the greatest martial masters in the entire history of the Fire Nation. Jeong Jeong was one of the 3rd Patriarch's many sons before he deserted. Many of its current members have trained with swords and spears under great swordmasters like Piandao, and many Yuyan archers have come out of this house. They distinguish themselves with their dedication to preserving the ancient traditions, not an easy task when the Fire Lord's House has been trying to destroy those very traditions and rewrite the history books. Of the 5 most powerful Houses, they are the most stable, the least political, and the most hard-working. They are also loved by many commoners for their selfless years of service in the military and domestic forces where they have served alongside commoners with honorable distinctions. They are the largest of the noble houses, boasting a clan of more than a thousand strong, and they are the backbone of the Fire Nation's forces, making up nearly ten percent of all high-ranking naval and army personnel.
The 4th House distinguishes itself through it's civil service. They are a House of doctors, lawyers, entrepreneurs, educators, archivists, philosophers, historians.. They run the libraries, the hospitals, and the universities. They control the "education" system--what gets taught, and what doesn't--with the Fire Lord's approval, of course.
The 5th House is distinguished by it's generations of philanthropy. While all the noble Houses have charities they maintain, the 5th House has turned philanthropy into an art form. The 5th House does a lot of "business" with the 3rd and 4th Houses, donating wings to hospitals, libraries, museums, and universities, as well as making sure poor children have access to scrolls and books, and backing charities that give aid to families of fallen soldiers and police officers. Houses 3, 4, and 5 have mostly good working relationships with one another.
Of course, there are exceptions. Lawyers have come out of the 3rd House, while the 5th House has its share of soldiers and martial arts masters. Not everyone from the 2nd House is a gangster, and the 4th House has a handful of cut throat politicians. But the members of each House usually stick to what they've been raised with because that's all most of them have ever known.
I haven't figured out how the other seven Houses distinguish themselves. Ideas and criticisms are welcome.