WASHINGTON Fears that the government will be forced to rescue Fannie Mae and Freddie Mac could well become a self-fulfilling prophecy.
Shares of the government-chartered mortgage finance giants plummeted Thursday and are trading at levels last seen in the early 1990s. If the prices don't recover, it will be harder for the two companies to raise more money through stock sales to compensate for losses from the housing bust. Investors are afraid their stakes will vanish if the government is forced to rescue the companies.
"The government has to step in and do something," said Friedman, Billings, Ramsey & Co. analyst Paul Miller.
Freddie Mac shares fell $2.26 or 22 percent, to $8, after sinking as low as $6.75 earlier in the day. Shares of Fannie Mae fell $2.11, or 13.8 percent, to $13.20, after earlier falling to $11.70.
Testifying on Capitol Hill, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke sought to calm investor jitters about the financial health of Fannie and Freddie, while urging Congress to give them new regulatory tools to better protect the country from economic and financial havoc if a major Wall Street firm were to fail.
Both regulators endorsed creating new procedures for the government to guide an orderly liquidation of a failing investment bank to minimize any fallout inflicted on the overall economy. Such procedures, already in place for commercial banks, might have made for a more orderly dissolution of investment firm Bear Stearns.
Bernanke defended the Fed's decision to provide about $29 billion in loan assistance in JPMorgan Chase & Co.'s takeover of Bear Stearns earlier this year, but he said it "is not something I want to do again."
Despite Wall Street's questions about Fannie and Freddie, and concerns about other investment banks faltering, Congress has a full plate and is unlikely to give financial regulators new powers before the next administration takes over.
Paulson told lawmakers that Fannie and Freddie are "working through this challenging period," but he would not say if they pose a risk to the U.S. financial system. "In today's world, it is not helpful to speculate about any financial institution and systemic risk."
James Lockhart, director of the Office of Federal Housing Enterprise Oversight, said the companies' capital levels are "well in excess" of government requirements.
Meanwhile, politicians vowed to intervene if necessary. "They cannot and will not fail," presumptive Republican presidential nominee Sen. John McCain told reporters.
"If they need additional support, Congress will act quickly," Sen. Charles Schumer, D-N.Y., said.
The two companies are coping with worries that they won't be able to withstand soaring losses from foreclosures and home loan defaults.
Washington-based Fannie Mae raised $7.4 billion in May to fortify its balance sheet. Freddie Mac, based in McLean, Va., plans to raise $5.5 billion, but it has been waiting to initiate the offerings because its stock is not yet registered with the Securities and Exchange Commission.
Congress created Fannie in 1938 and Freddie in 1970 to keep money flowing into the home-loan market by buying up mortgages and bundling them into securities for sale to investors worldwide thereby making home ownership affordable for low- and middle-income Americans.
Today the companies hold or guarantee around $5.3 trillion in home-loan debt, though under a 1992 law they are required to hold only a fraction of what is mandated for commercial banks as a financial cushion against risk.
Some say those capital requirements should be far higher, and believe Congress should mandate bank-like standards. "These guys were skating on such thin ice that, when the stress came, we're starting to see some cracks" said Johns Hopkins University fellow Thomas Stanton.
While the government isn't obligated to assist Fannie or Freddie in a financial emergency, there is a widespread perception that they would be bailed out if there is a collapse. The idea they are "too big to fail" enables the two companies to borrow relatively cheaply on global markets by issuing top-rated mortgage-backed securities.
Fannie and Freddie play a vital role in the U.S. mortgage market, one that has grown dramatically over the past year after the subprime mortgage market's collapse. The companies issued about three-quarters of all new mortgage-backed securities in the second quarter of 2008, up from under 40 percent in 2006, according to trade publication Inside Mortgage Finance.
If fears about Fannie and Freddie's health continue to grow causing the cost of routine debt sales to soar even further the Federal Reserve and Treasury Department would likely provide emergency support to ensure the companies can continue to buy loans, said Alexandria, Va.-based banking industry consultant Bert Ely, based in Alexandria, Va.
"There would have to be some effort to salvage them," Ely said.
Still, some question whether such anxieties are justified.
"It's way overblown," said mortgage industry consultant Howard Glaser. "Psychology is the major problem here."
Glaser, a former housing official in the Clinton administration, says the companies' government regulator could give them more flexibility and reduce the need to raise money by loosening capital requirements.
The Treasury Department has long worked on plans for what to do if a large financial firm such as Fannie or Freddie failed, but a department spokeswoman declined to comment on whether such plans have been accelerated recently.
Critics warn that the companies could threaten the economy and do not have enough capital to withstand financial turmoil. But Fannie and Freddie executives have consistently called such worries unfounded.
Freddie spokeswoman Sharon McHale said the company "continues to hold a surplus above its regulatory requirement that will enable it to continue to support the nation's housing markets."
Fannie Mae is "managing our business and maintaining a capital position that will allow us to fulfill our congressionally chartered mission now and in the future," spokesman Brian Faith said, noting that Fannie has raised more than $14 billion in capital since last November.