Investors dumped the stocks of Fannie Mae and Freddie Mac after Barron's reported the increasing likelihood of a U.S. Treasury bailout that would approach nationalization of the two housing finance titans.
The weekly financial newspaper said such a move could wipe out existing holders of the largest U.S. home funding companies' common stock.
Preferred shareholders and even holders of the two government-sponsored entities' $19 billion of subordinated debt would also suffer losses.
Shares of Fannie and Freddie , the two providers of home mortgage funding, fell more than 16 percent and some of their bonds sharply underperformed Treasuries.
The selloff pushed the rest of the stock market lower.
A spokeswoman for the U.S. Treasury said the department has no plans to use its authority to backstop the two funding agencies. That authority was greatly increased by a rescue plan approved at the end of July.
"The Barron's article overstated Freddie Mac's financial situation," Sharon McHale, a Freddie Mac spokeswoman, told Reuters. "We continue to be adequately capitalized."
The poor performance of the U.S. mortgage market has pulled home loan rates up by about a percentage point from a year ago, just as the worst housing market since the Great Depression struggles to find a bottom.
Overseas central banks have sold nearly $11 billion from their holdings of agency-related securities in the past four weeks, awaiting clarity on the extent and nature of U.S. government backing of the two faltering companies, known as GSEs.
Video: Assessing the Fallout in Financial Stocks
"There is a lot of uncertainty with what happens in terms of capital raising and a lot of investors are in a wait-and-see mode," said Rajiv Setia, analyst at Barclays Capital.
"From a GSE perspective, as long as they get funding it does not matter at what price as they will just pass it on with higher mortgage rates."
The value of some of the two companies' debt, which is at the biggest risk of loss in the event of a government rescue, fell to a record low in comparison with similar Treasury securities.
Spreads on Freddie Mac 10-year subordinated debt widened over Treasury notes to a bid of 370 basis points and offer of 325 basis points, from a close of 285 basis points on Friday, according to one investor, citing a dealer's data.
An insider in the Bush administration told Barron's that Fannie and Freddie "are being jawboned" by the Treasury Department and their new regulator, the Federal Housing Finance Agency, to raise more equity.
But government officials do not expect the agencies to succeed, Barron's reported.
If the GSEs fail to raise fresh capital, the administration is likely to mount its own recapitalization, with the Treasury infusing taxpayer money into the agencies, according to the Barron's source.
The report said an equity injection by the government would be a quasi-nationalization -- without having to put the agencies' liabilities on the U.S. balance sheet, and thusdoubling U.S. debt.
Merrill Lynch also weighed in on Freddie Mac on Monday, saying it will likely raise fresh capital in the third quarter, comprised of at least 50 percent common stock. Merrill also cut its price target on the company.
Freddie Mac early Monday said it will sell $3 billion of five-year notes Tuesday in a sale that is sure to draw heightened scrutiny to gauge investor interest.
"Lukewarm was my overall characterization," Nancy Vanden Houten, analyst at Stone & McCarthy Research Associates, said in an e-mail on Freddie Mac's $4 billion debt sale. "The bid-to-cover ratios were weak for all three bill auctions. Spreads weren't uniformly bad, however. The Barron's story seems to be getting a lot of attention, rightly or wrongly."
A bid-to-cover ratio reflects the amount of bids compared with the amount offered. A lower ratio indicates weaker demand.
Several U.S. insurance companies have "substantial" exposure to securities issued by Fannie Mae and Freddie Mac but should avoid big write-downs because of the federal government's backing of much of those securities, A.M. Best Co said Monday.
The U.S. insurance industry invested $371 billion in securities issued by the mortgage financiers at year end, but $366.4 billion of the sum was in fixed income, A.M. Best said.
"Much of the industry's exposure represents fixed-income securities, which should benefit from the added financial backing of the federal government," A.M. Best said.
