The odds of government intervention suddenly spike. That's more bad news for markets and the economy. By Fred W. Frailey, Editor July 11, 2008 Fannie Mae and Freddie Mac are not banks. But like most financial companies, they stand or fall on public trust -- and right now, fewer and fewer people are confident that the two government-chartered mortgage-finance companies can survive on their own.Result: The crisis that has enveloped the entire U.S. financial system has visibly worsened. The woes of Fannie and Freddie burst into public view on Thursday, July 10, in a front-page Wall Street Journal story that revealed the government had begun contingency planning, were the two publicly traded companies to fail. Freddie's shares fell 22% and Fannie's dropped 13% that day on the news. Early Friday, their plunge accelerated -- Freddie shares were off another 33% at one point, to $5.40, and Fannie down 29%, to $9.31. And down with them went the stock market, with the Dow Jones industrial average shedding more than 200 points, to dip below the 11,000 level at one point, the first time that has happened in two years. Later in the day, rumors that the Federal Reserve Board might seek to aid Fannie and Freddie, as it previously has intervened with some investment banks, calmed the market. The Dow Jones average regained half of what it had lost, closing on July 11 at 11,100, down 1.1%. Fannie's and Freddie's shares bounced off their low points as well. FNM closed at $10:25, down 22%, and FRE at $7.75, down 3%. But extreme swings in the stocks are clearly still possible as traders react sharply to every news development. Advertisement Fannie and Freddie are crucial to the smooth flow of everyday American life. They are the cement that holds the nation's housing markets together. The companies buy home loans from banks that issue them, repackage those loans as bonds, and either hold them as assets or sell them to the public. Roughly 70% of U.S. home mortgages pass through the hands of Fannie and Freddie. Together, they own or guarantee $5.2 trillion in mortgages. Without Fannie and Freddie, it could soon become all but impossible to buy or sell a home. But to continue to provide this service, they must be able to borrow cheaply, and that window may be closing as the financial community loses faith in their ability to continue as going concerns. The cost of borrowing has gone up. On July 10, their bonds yielded 0.78 percentage point more than did comparable Treasuries -- double the gap of a year ago. In addition, the two entities will require heavy infusions of capital. At last word, just 1.22% of Fannie's single-family loans that it owns or guarantees were 90 days or more overdue. Freddie's number was 0.81%. Still, the companies have reported a combined loss of $11 billion for the nine months through March 31 because of foreclosures on mortgages they own, plus provisions for future losses. And this may be only a taste of what lies ahead. Moreover, their combined capital of $81 billion represents just 1.6% of the mortgages they own or guarantee. Freddie's lack of foresight is damning. It contributed to the mortgage crisis -- some say helped cause it -- by pumping money into a system that leaked like a sieve. And late last year, with the stock still above $30, it planned to raise $6 billion in a stock offering that would have put it on firmer financial ground. But it dithered. Now the company itself is worth less than $4 billion, and the odds of its raising money without government help are slim. Fannie Mae, at least, raised more than $2 billion in May. Advertisement Any number of ideas are being floated to pull Fannie and Freddie out of danger. The trouble is, by itself, each proposed solution is inadequate to the need. Both entities can borrow from the Treasury. But that line of credit, set by Congress at $2.25 billion, is a drop in the bucket. Suggestions were made that they be allowed to borrow from the Federal Reserve, but the Fed has not warmed publicly to this idea. Big issues of stock in Fannie and Freddie are another possibility, one that would shrink the equity of current shareholders. But with their stock prices as low as they are, it's hard to see how this would raise enough needed capital. All along, the financial community has been sanguine about the worsening affairs of Fannie Mae and Freddie Mac because it assumed that if push came to shove, the government that set up these entities would come to their rescue. In the worst case, that may be what happens, in the form of a conservatorship. Under a 1992 law, for a conservatorship to occur, the companies' chief regulator, James B. Lockhart, director of the Office of Federal Housing Enterprise Oversight, would need to conclude that Fannie, Freddie or both are "critically undercapitalized." Advertisement A conservator would have the power to run the companies -- but not the authority to shut them down. According to the New York Times, the shares of the companies would become all but worthless, and losses on mortgages they hold or guarantee would be made up by the federal government. It's still hard to tell whether such a dire outcome will occur. Public officials, from Treasury Secretary Henry Paulson to Fed chairman Ben Bernanke, and the companies themselves are keeping a stiff upper lip, trying to calm the waters by issuing statements saying that all is well -- even if it isn't. In case you forgot, however, that's how you try to forestall a run on the bank.