Update: Fannie Mae (FNM) and Freddie Mac (FRE) came under renewed pressure Wednesday amid increasing worries about the mortgage lenders’ financial health. Shares of Fannie fell 6% and rival Freddie dropped 3% in midmorning action after The Wall Street Journal reported the companies could be forced to raise more capital. The selloff came even after Freddie’s financial chief rebutted the report in a meeting with analysts in New York. “There is no dilutive capital raise plan,” he said, Bloomberg reports.

Wednesday’s selloff helped erase some of the gains made in Tuesday’s marketwide rally. Even after yesterday’s double-digit percentage gains, shares of both Fannie and Freddie have fallen more than 40% in 2008, as house prices have fallen and projected credit losses have risen. Those trends have fueled worries about the strength of the companies’ balance sheets, even after Freddie raised $6 billion and Fannie almost $8 billion late last year.

Worries about the companies’ health have intensified with Washington’s efforts to expand Fannie and Freddie’s role in supporting the housing market by allowing the two to buy bigger mortgages. Those fears lifted briefly Tuesday, when the Fed set plans to let banks and brokers use mortgage-backed securities as loan collateral, but the Journal contends that the sharp decline in the companies’ shares over the past year shows the market already expects a new share issue.

Adding to worries that shareholders will be diluted, the Journal notes that the companies’ regulator, the Office of Federal Housing Enterprise Oversight, has stated its approval of new capital raising at Fannie and Freddie. While Ofheo recently deemed both companies well capitalized as of Dec. 31, director James Lockhart tells the Journal that “raising capital would put them in an even better position to support the mortgage market.”

Stocks rallied Tuesday as traders embraced the latest government efforts to ease the pressure on the financial system. The Fed said Tuesday morning it will expand its securities lending program to permit banks to use triple-A, private-label, mortgage-backed securities as collateral. The Fed said it will lend as much as $200 billion in this fashion over 28 days, rather than overnight as previously.

The decision set off a sharp rally in shares of big mortgage lenders such as Fannie Mae (FNM), Freddie Mac (FRE), Countrywide (CFC) and Washington Mutual (WM), all of which had swooned in recent days amid fears that the near collapse of leveraged mortgage investors such as Carlyle Capital would flood the market with more mortgage bonds.

The new program, called the TSLF for term securities lending facility, adds to a range of government-sponsored efforts to unlock the credit markets. At the end of last year the Fed used another novel program, the TAF or term auction facility, to bring interbank lending rates down. Those rates have spiked again this month, but Jeff Miller, CEO of investment adviser NewArc Investments in Naperville, Ill., says investors make a mistake when they discount the government’s capacity for devising solutions to messy problems such as the credit crunch.

“Wall Street analysts do not understand how government works,” he wrote last week at his Dash of Insight blog. “Because the pace of action is slower than trading they infer stupidity and ignorance.  This is not true. Solutions develop, but not always at the pace we hope for.”

Fannie Mae (FNM) could be under more pressure when trading opens Monday in New York. Shares fell almost 3% in Europe after an article over the weekend in Barron’s suggested the giant mortgage lender could need a government bailout if the housing market continues to swoon. “Its balance sheet is larded with soft assets and understated liabilities that would leave the company ill-equipped to weather a serious financial crisis,” Jonathan Laing writes. “And spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses over the next two years that will severely test Fannie’s solvency.”

Worries about the financial strength of Fannie and other lenders consumed the market late last week, as shares in the banking sector fell sharply both Thursday and Friday. Fannie raised billions of dollars in new capital late last year through a sale of preferred stock, but a report in The Wall Street Journal hints that the company is considering going back to the trough as CEO Daniel Mudd makes his annual trip to Asia. With the market as turbulent as it has been, he tells the Journal, “You need to remain long capital.”

Fannie Mae (FNM) plunged 12% to a 12-year low after a default notice at Carlyle Capital left the financial sector swooning. Guernsey, U.K.-based Carlyle Capital missed four margin calls yesterday totaling more than $37 million, Bloomberg reports. Carlyle Capital, run by private equity giant Carlyle Group, raised $300 million in July and used loans to buy about $22 billion of securities issued by Fannie Mae and Freddie Mac (FRE), the government-sponsored mortgage lenders, Bloomberg reports.

 The default at Carlyle Capital adds to worries that troubled hedge funds will be forced into fire sales of mortgage-backed securities, forcing prices down further. That would be bad for big holders of the securities such as Fannie, Freddie and other big financial institutions. The unrest comes as rates for short-term funding used by banks have hit their highest levels since debt markets seized up in December, The Wall Street Journal reports. Adding to the worries Thursday: a rumor, since batted down by Treasury, that the U.S. would step in to explicitly guarantee Fannie and Freddie’s debt.

Like Thornburg Mortgage (TMA), a jumbo mortgage lender that has seen its shares plunge more than 80% in a week amid missed margin calls and default notices, Carlyle Capital was done in by declines in the mortgage securities markets that led its lenders to demand more collateral. Echoing recent remarks by Thornburg chief Larry Goldstone, Carlyle Capital chief John Stomber said mortgage market values have come unmoored from the long-term value of the debt. “Unfortunately, this disconnect has created instability and variability in our repo financing arrangements,” he said, the Journal reports. “Management is actively working with the company’s repo counterparties to develop more stable financing terms.” In the meantime, expect more instability in the financial stocks.

Adding to Thursday’s selloff in Fannie Mae (FNM) and Freddie Mac (FRE) was a rumor that the government would issue a statement explicitly guaranteeing the companies’ debt. The rumor may have contributed to Fannie stock’s dropping to a 12-year low, by suggesting the government-sponsored mortgage companies’ balance sheets may be in worse shape than the market believes. But shares of Fannie and Freddie posted a modest bounce just after 10 a.m. EST, after a spokeswoman at the Treasury Department told The Wall Street Journal that the explicit-backing rumors are “absolutely not true.”

Fannie and Freddie have historically gotten cheaper funding in the market based on the assumption that the feds would step in to support the companies if they got into trouble. But Dow Jones reports that even Fannie and Freddie securities were finding little demand in the repurchase market Thursday morning, as investors continue to flock to Treasury securities - which, unlike GSE debt, do carry an explicit government guarantee. “Until real money steps up it will keep getting worse,” a fixed income analyst told Dow Jones, “and for now real money is watching things get cheaper and biding their time.”

Fannie Mae (FNM) fell 4% in midday trading in spite of a modestly encouraging analyst note out this morning. Analysts at Morgan Stanley upgraded Fannie’s stock to equal-weight from underweight, saying their weak outlook for last week’s fourth-quarter numbers is now reflected in the stock. Morgan Stanley said it continues to like rival mortgage investor Freddie Mac (FRE) better, but is taking off most of its short position on Fannie.

The firm says the risks of a further decline in Fannie stock are evenly matched with the prospect that investors who don’t own it will miss out on a rally based on its modest multiple - the stock is trading below regulatory book value - and its earnings power going several years out. But how the company handles the next year remains an open question, Morgan Stanley says. “On the negative side, we cannot yet bracket a reasonable worst-case scenario for credit losses,” the firm writes. “Prime mortgage delinquencies are accelerating, and the full impact of labor market deterioration has yet to be felt.”

Fannie Mae (FNM) and Freddie Mac (FRE) ended an eventful week on a low note Friday. William Poole, president of the Federal Reserve Bank of St. Louis, warned in a speech to the U.S. Monetary Policy Forum in New York that the government-sponsored mortgage lenders could be the source of “substantial problems” should house prices continue to decline sharply this year.
 
Poole, a longtime critic of Fannie and Freddie, said there are two ways the government can discourage financial actors from taking excessive risks: by not bailing out firms that fail and by forcing firms to maintain adequate capital. Poole said that while U.S. banks have generally been well capitalized and therefore able to absorb the losses tied to the debt market problems of the past year, “I am more skeptical of the financial strength of the GSEs.” The comment comes days after Fannie and Freddie, which bear much lighter capital requirements than do banks, reported a combined fourth-quarter loss of $6.1 billion.
 
Poole continues that if Fannie and Freddie end up shouldering outsize losses that deplete their capital, the blame would lie with the implicit government guarantee of the companies’ obligations.

“I do not have any information on the GSEs that the market does not also have,” Poole says. “Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.” (Hat tip: Abraham Pumblechook.)

Freddie Mac (FRE) posted a bigger-than-expected fourth-quarter loss and warned that a weakening economy will lead to higher credit losses in 2008 and 2009. The McLean, Va., mortgage lender lost $2.5 billion, or $3.97 a share, for the quarter ended Dec. 31, compared with a year-ago loss of $401 million, or 73 cents a share. Analysts on Wall Street were looking for a loss of $2.04 a share.

Freddie said the latest-quarter loss reflected mark-to-market losses of $800 million on the value of the company’s credit guarantee asset and $2.3 billion on the value of the company’s derivatives portfolio, both due to the impact of declining long-term interest rates. Credit-related expenses, consisting of provision for credit losses and real estate owned operations expense, were $912 million for the fourth quarter, compared to $1.4 billion for the third quarter. Freddie said it expects total credit losses of $2.2 billion in 2008 and $2.9 billion in 2009, as a result of the deteriorating housing market.

The company also said it had adopted new accounting policies that “significantly enhance the transparency and understandability of the company’s financial results, promote uniformity in the accounting model for the credit risk retained in its primary credit guarantee business and better align revenue recognition to the release from economic risk of loss under its guarantee.” Under Freddie’s old accounting, its fourth-quarter loss would have been $3.7 billion.

The shift comes on the day that the company returned to timely financial reporting following several years of late filings as Freddie sought to fix problems with its accounting and financial oversight. Freddie’s promise to return to timely reporting was partly behind Wednesday’s decision by its regulator, the Office of Federal Housing Enterprise Oversight, to lift limits on the mortgage-portfolio holdings of Freddie and its government-sponsored sibling Fannie Mae (FNM). The hope is that Fannie and Freddie can ease the housing crunch by making the mortgage market more liquid. But as Thursday’s numbers show, the companies have plenty of problems of their own.

A frenetic rally in shares of Fannie Mae (FNM) and Freddie Mac (FRE) eased as Wall Street mulled over the details of a regulatory decision to lift caps on the growth of their mortgage portfolios. After earlier rising as much as 16 percent, Fannie and Freddie had given up all their gains and were unchanged action.

Wednesday’s move by the Office of Federal Housing Enterprise Oversight could allow the companies to expand their purchases of mortgage securities. Legislators have been hoping they’ll do just that in a bid to ease the pain of the housing crisis. But merely lifting the mortgage caps is just a first step in the eyes of some. Sen. Chuck Schumer, who last year sponsored legislation that would have forced OFHEO to raise the companies’ mortgage caps, now wants the regulator to reduce the amount of capital it forces the companies to hold to cushion against future losses.

“This is a long overdue step, but certainly a welcome one,” Schumer said in a press statement. “Just as important is OFHEO’s willingness to ease the capital surcharge requirements that continue to hamstring the GSEs. OFHEO should announce a plan to lift that surcharge immediately.”

OFHEO chief James Lockhart has indicated he’s open to reducing the capital surcharge, but not just yet, amid worries that a declining housing market will stick the companies with billions of dollars in credit losses and writedowns of derivative positions. Wednesday morning’s financial update, in which Fannie Mae said it lost $3.56 billion for the fourth quarter, shows those concerns aren’t going away any time soon.

Shares in Fannie Mae (FNM) and Freddie Mac (FRE) fell after Goldman Sachs downgraded the mortgage firms to sell from neutral, saying it expects $4.2 billion of writedowns at Freddie and $2.6 billion worth at Fannie when the government-sponsored enterprises report fourth-quarter earnings later this week. Goldman even recommended that investors short Freddie Mac shares ahead of Thursday morning’s expected earnings release, which is expected to show a big quarterly loss. Goldman’s comments come just days after analysts at Merrill Lynch downgraded Fannie and Freddie to sell as well, citing deteriorating financial market conditions and worsening credit performance. For its part, Goldman expects Fannie to lose $1.75 a share for the fourth quarter and Freddie to post a loss of $3.70 a share. On a slightly more optimistic note, the Goldman says it doesn’t expect the firms to have to raise capital again in the first half of this year, in the wake of some $13 billion worth of preferred stock sales late last year. But beyond that, Goldman suggests, all bets are off. “Further capital raises are unlikely,” Goldman writes, “but not impossible.”