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Fannie Mae & Freddie Mac: Beginning of a Bottom?

The dual crisis at Fannie Mae and Freddie Mac marks not just a crucial juncture for the two mortgage giants, but also a potential turning point for the broader stock market and its prolonged quest for a bottoming point.

CNBC

With reverberations spreading through the entire banking sector, some analysts believe the latest chapter in the credit crisis could send financials to a capitulation point that most believe is necessary before the market can recover. The capitulation, according to this theory, would create wreckage among weaker banks, sending their shares to bargain-basement levels and encouraging industrial investors to swoop them up in a large-scale shakeout for the banking industry.

"It may be a good proxy for that," said Richard Sparks, senior analyst at Schaeffer's Investment Research. "It might simply be that we need to see some of the bigger financials step in and start to buy. Then you've got evidence that people in the industry will start buying and they think the worst is over."

To be sure, though, such a progression of events wouldn't happen overnight.

Second-quarter earnings season begins in earnest next week, and there won't be a true picture of where financials and the rest of the market stand until Wall Street sees the corporate outlook for the rest of the year.

And real estate continues to frustrate the market, with mortgage lenders crushed by falling property values and foreclosures. Until the U.S. housing situation gets straightened out, the pressure on the broader market will be onerous, with banks hit especially hard.

On the other hand, the type of bad-news cycle that the Fannie-Freddie crisis has created is just the kind of thing that usually precedes a bottoming.

"Within the bear market context, you're going to see some major upward spikes in the market, but they will lead to selloffs," said The Hartford Chief Investment Strategist Quincy Krosby, who believes a significant consolidation in banks is on the way. "The latter stages of the bear market are historically the most dramatic in terms of the spikes up and ultimately lead to a selloff."

Amid some of the wildest trading swings seen in months, bank stocks were up, down and in between Thursday as the market scurried to assess the problems at Fannie and Freddie . The two government-sponsored enterprises, or GSEs, face a severe capital crunch that led former St. Louis Fed President William Poole to call them "insolvent" and analyst Len Blum, managing director at Westwood Capital, to conclude that Freddie has a $5 billion negative net worth.

Blum said the Fannie-Freddie situation compounds the housing problem and imposes a substantial drag on stocks. And he noted that even though the problems at the two institutions are being cast as one event, Freddie is in considerably worse shape than Fannie.

"As far as Fannie and Freddie are concerned, they're a train wreck waiting to happen," he said. "If you mark (Freddie's) assets to market they're already bankrupt. That's what's pulling the market today—the realization that these institutions are in really bad shape."

While few think the government would let Fannie and Freddie fail, their precarious standing is still creating market fear—another vital ingredient for capitulation.

"The inevitable right now is that Freddie and Fannie are going to be nationalized unless they raise a lot of money," Blum said. "The rest of the sector is just following them because their risk of failing is so high. If they fail, it would make Bear Stearns look like a picnic."

Bottoming Out, Cleaning Up

A market capitulation would mark the culmination of a torrent of bad results from the Fannie-Freddie debacle. Some hope more good can come for the market, particularly in the mortgage industry.

The firms' problems came to pass initially through a complicated equation involving risky debt backed by taxpayer guarantees. Moreover, reductions in government-mandated capital requirements put Fannie and Freddie in a position where their solvency came into question—most recently by Lehman Brothers on Monday—which has created a sense of urgency about getting the situation resolved.

"The government can stop the bleeding if they take immediate action," Blum said. "They can't just say, 'Yes, they're in compliance with regulatory capital,' because it's all based on estimates and these entities can't estimate very well."

Yet there seems to be little appetite on Capitol Hill for devising a bailout strategy for Fannie and Freddie.

Instead, lawmakers were hashing out a bill that would button up the loose regulations that allowed the two entities to expose themselves to so much risk with so relatively little capital to back it up.

"We would hope that would send a signal to the markets that we are watching what's going on," said Steve Adamske, spokesman for the House Financial Services Committee.

Blum and Krosby said returning to a more transparent mortgage industry is one of the best things that could come from the Fannie-Freddie fallout. It also would eventually help stabilize the stock market, they said.

"The good old days may not be very exotic, but that would help with the solvency of the banking system," Krosby said. "The investment banks in particular will continue producing derivative products. They always come up with something interesting and innovative and exotic, but I think they've learned to be based on reality."

Knowledge of where the banks really stand will in turn help the banking consolidation that will help trigger the market turnaround, said Sparks of Schaeffer's Investment Research.

"It's going to take those stable financial companies ... seeing that the worst is over, and these prices that they can purchase these companies are at a level that is attractive to them," Sparks said. "They've got to be comfortable with the balance sheets. It's only then that they will step in."