Fannie, Freddie On a Tightrope

With major newspapers publishing front-page reports about the mounting peril facing the companies, including a possible government takeover, investors ran for the door. On July 11 alone, more than 400 million shares of Fannie Mae changed hands -- 20 times as much volume than on a typical day at the end of June -- and its price fell by 22 percent.

"There was panic-dumping going on," said Samuel Lieber, president of Alpine Mutual Funds. "The classic extremes of Wall Street came into play: fear and greed."

The downward spiral was exacerbated by the large number of investors who bet on the stocks' decline and sold the stocks short. The number of Freddie Mac shares sold short had nearly doubled from March 31 to June 30, to 82.8 million. For Fannie Mae, the number of short sales more than doubled, to 138.7 million from 63.1 million, over the same period.

Then, from June 30 to July 15, short sales of Freddie Mac rose 28 percent and increased 11 percent for Fannie Mae, according to Bloomberg News.

"We became a very popular, almost can't-lose, short," Syron said.

Wall Street insiders called the sell-off a classic panic. Syron said the selling binge was "fear- and emotion-driven" and occurred even though "the fundamental economics of both companies I don't think was a lot different than it was a month ago."

Worried that the stock slide could cripple the companies and undermine markets around the world, Treasury Secretary Henry M. Paulson Jr. went into emergency mode. To prevent further erosion, the Treasury, the Federal Reserve and company officials worked through the weekend of July 12 and 13 to devise a rescue plan. It made more explicit what had been only implicit before: that the U.S. government would stand behind Fannie Mae and Freddie Mac. The government offered new loans and outright purchases of their stock if needed.

The SEC also made it harder for investors to undermine Fannie Mae's and Freddie Mac's stocks by tightening the rules governing short sales. The order was temporary. The SEC is scheduled to announce today whether it will extend it and, if so, for how long.

The SEC's order in particular caused what analysts call a "short squeeze" among Fannie Mae and Freddie Mac short sellers, said Art Hogan, chief market analyst at Jefferies & Co. A short squeeze pushes the price of a stock higher as short sellers liquidate and repurchase stock to cover their positions. The amount of short selling in Fannie Mae and Freddie Mac plummeted by 90 percent from July 14 to July 21 due to the SEC's emergency order, according to an analysis of market statistics by S3 Matching Technologies.

By July 18, the stocks had nearly doubled from their lows, hit earlier that week.

But last week, the companies' shares slumped again -- though less severely, with Fannie Mae down 13.8 percent and Freddie Mac 9.9 percent -- after existing-home sales reached their lowest level in a decade and investor Bill Gross of Pimco predicted that the housing slump could cost firms $1 trillion. Yesterday, Fannie Mae shares fell 10.7 percent and Freddie Mac dropped 6.7 percent.

"We are in a period of very high volatility for them," said Deborah Lucas, a finance professor at Northwestern University. "It's off the charts."