By MICHAEL M. GRYNBAUM

Published: July 11, 2008

Fannie Mae and Freddie Mac,
the mortgage lenders at the heart of the nation’s housing finances,
fell to their lowest share prices in 17 years on Thursday on concern
that the companies could face the possibility of a government bailout.

Provocative
comments from a prominent central banker — who labeled the firms
“technically insolvent” — and a harsh report about Freddie Mac from
analysts at UBS led to a rapid sell-off of the shares of the companies.

Freddie
Mac’s stock plunged more than 30 percent and Fannie Mae’s more than 20
percent in the first hour of trading. At 1 p.m., Freddie Mac was down
20 percent, to $8.26, and Fannie Mae was down 10 percent, to $13.71. It
was the second straight day of declines for the companies.

Liquidity
problems at the two firms, which operate under an implicit government
guarantee, could cause catastrophic consequences for the American
economy. Analysts expect the companies to announce a new round of
write-downs and possibly be forced to raise capital by issuing
additional stock, which would dilute their value for current
shareholders.

In the last week alone, Freddie has lost 47
percent of its value, and Fannie is off 28 percent. Expectations of
default at the companies has also risen; it costs three times as much
today to guarantee a two-year Fannie bond as it did three years ago.

The
companies were designed to be considered nearly as safe as government
bills. But the yield on the 10-year Fannie benchmark note is now
nine-tenths of a percentage point higher than the 10-year Treasury
bond, a yawning gap that underscores how risky Fannie and Freddie have
become in the eyes of investors.

The cost of protecting debt from Fannie and Freddie has risen significantly, as well.

Thursday’s
sell-off caps a week of painful days for the two giant lenders, which
are by far the biggest providers of financing for domestic home loans.
Investors and analysts are increasingly anxious that the companies do
not have enough capital on-hand to guarantee their loans.

Treasury Secretary Henry M. Paulson Jr.,
testifying before Congress on Thursday morning, immediately sought to
reassure markets about the health of Fannie and Freddie.

“Fannie
Mae and Freddie Mac are also working through this challenging period,”
he said early in his testimony before the House Financial Services
Committee. “They play an important role in our housing markets today
and need to continue to play an important role in the future. Their
regulator has made clear that they are adequately capitalized.”

His
comments were an attempt to mitigate a provocative statement from a
former president of the St. Louis Federal Reserve, William Poole. In an
interview on Wednesday, Mr. Poole, considered a longtime critic of the
two companies, called Fannie and Freddie “insolvent” and said the
government may be forced into a bailout.

“Congress ought to
recognize that these firms are insolvent, that it is allowing these
firms to continue to exist as bastions of privilege, financed by the
taxpayer,” Mr. Poole told Bloomberg News.

Analysts at UBS, the
investment bank, issued a report on Thursday that expressed doubts
about Freddie Mac’s ability to maintain a sufficient amount of capital.

“Although the company has announced a $5.5 billion capital
raise, we are still trying to determine if the resulting level of
capital will be sufficient in the circumstance that the company’s
credit quality deteriorates in a manner more consistent with our
expectations,” the analysts wrote.

The concern over the health of the companies quickly entered the political realm. Senator John McCain,
the presumptive Republican presidential candidate, said Fannie and
Freddie “are vital to Americans’ ability to own their own homes.”

“They will not fail; we cannot allow them to fail,” Mr. McCain said while campaigning in Michigan.

Lehman Brothers, one of the biggest guarantors of Fannie and Freddie, fell 9 percent in early trading, to $17.92.

Stephen Labaton contributed reporting.