Troubles at Fannie and Freddie: What It Means for Investors

Will shareholders lose out even if there is a government bailout?

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How big is too big to fail? We may be about to find out. This week's dizzying tumble in Fannie Mae and Freddie Mac, government-backed lenders who hold or guarantee more than $5 trillion in securities backed by American mortgages, is the latest ignominy to befall markets in the wake of the housing and credit crisis.

At one point on Friday, both had slumped 40 percent, though shares rebounded late in the day. The day's volatile swing follows a week of heavy selling that nearly halved the value of both stocks from Monday's open because of fears that the government would be forced to bail out the capital-light lenders. "The shares are likely going to zero," said Peter Boockvar, an equity strategist at Miller Tabak.

Others analysts, including Citigroup's Brad Ball, said Washington isn't interested in a bailout and said regulators should express confidence in the government-sponsored enterprises, or GSEs. He's betting the two have enough capital to squeak by and that recent selling is "overdone."

The question remains as to whether the government will have to step in and live up to its commitment to back the lenders, and what impact that will have on already tight credit. Yesterday, speculation mounted on reports government officials were considering a takeover of the pair. Today, Treasury Secretary Henry Paulson issued a statement saying "our primary focus is supporting Fannie Mae and Freddie Mac in their current form."

That left traders hoping for swift government action cold. "Before the Paulson comments, I would have told you days or weeks considering what's going on the equity of these names," Boockvar says. "But considering Paulson seems to want to sit back and see how things play out, it's impossible to say. The problem is things are happening so much faster than the government is able to react."

In any case, it's a mighty fall for the GSEs. Analysts have long touted the agencies as gold-standard investments, thanks to their heft and backing from the U.S. government. Shares were often viewed as trading at a premium because of that unique status.

What's the fallout for markets and the economy? For context, if Bear Stearns was too intertwined with the global financial system to be allowed to fail because of its role in a vast web of global trading, Fannie and Freddie are more like two pillars between which that web is strung.

The most obvious symptom of their falling share prices will likely be even tighter credit. Lending standards are already prohibitive for lots of mortgage seekers. Unless Fannie and Freddie continue to grow their businesses to make up for already steep declines in other types of available credit, the situation for borrowers will probably get worse.

That credit function may be the most important job of the GSEs. Goldman Sachs economist Jan Hatzius notes that of the almost $25 trillion of lending capacity to the nonfinancial private sector, roughly half "is either stagnant or shrinking at present." That means the other half—including the $5.3 trillion book at Fannie/Freddie—needs to keep growing if credit is to continue flowing.

For stocks, the situation looks little better. The Dow slumped 250 points to a two-year low, heading below the 11,000 mark. It is possible declines could be stemmed next week. The implosion of Bear Stearns and the Federal Reserve's decision to back its loans provided a temporary floor to stocks. Unfortunately, looking further ahead, investors have to realize that the credit crisis has not ended and will probably continue at least through the end of the year. That will crimp companies' ability to raise capital and keep pressure on consumer spending. Lenders' pain also spells more trouble for financials stocks. Lehman Bros., another huge bank plagued by speculation that its exposure to the mortgage sector could lead to an eventual sale of the company (or worse), saw shares slump nearly 20 percent Friday.