Will Fannie and Freddie Trigger a Systemic Crisis?

Last Thursday I discussed whether or not Fannie Mae and Freddie Mac should be nationalized. Today, investors whacked both Fannie (-16%) and Freddie (-18%). It seems that investors are waking up to the fact that these Government Sponsored Enterprises are not immune to the credit crisis. I quote the following from the Wall Street Journal:

"Investors dumped shares and bonds of Fannie Mae and Freddie Mac, signaling a dramatic loss of confidence in two government-sponsored mortgage companies considered crucial to restoring the health of the housing market.

Shares of the two companies dropped Monday to their lowest levels in more than 14 years, and at one point, Freddie Mac had lost nearly 30% of its value."

These are not tech stocks folks! These are the two most important mortgage companies in the world, guaranteeing over $5 trillion in mortgages or half of all mortgages outstanding. If either Fannie or Freddie go belly-up, this could act as a catalyst for a systemic crisis. The bond market has taken notice. The chart above (click image to enlarge) was taken from Prudent Bear. It shows that the spread between Fannie Mae Mortgage Backed Securities vs. 10-year Treasuries is widening as investors question the quality of the GSE guarantees.

Stay tuned...last week's rebound in financials may be short-lived. Investors should continue to underweight this sector; there is no need to catch a falling knife.

Update 08/07/08: Comments from a federal regulator that a proposed accounting change should not dictate capital requirements for home finance companies sent shares of Fannie Mae climbing 6.4 percent to $16.75 before the bell, while Freddie Mac rose 8 percent to $12.85. No matter what any federal regulator says, I would not touch these companies and would use any rally to reduce exposure and/or build short positions.

Note: I added Investment Postcards from Capetown on my blog list. I recommend you to read Donald Coxe's latest investment recommendations. I also added Cabot on my market research.