Stocks, dollar slide on latest credit crisis fear

By Herbert Lash

NEW YORK (Reuters) - Fear the two largest U.S. mortgage finance companies are in such poor health that they need a government bailout pushed financial markets lower on Friday, although stocks pared losses as officials began to talk of safety-net moves for the ailing sector.

In a wild trading day fueled by speculation of whether the U.S. government will rescue troubled housing finance giants Fannie Mae (FNM.N) and Freddie Mac (FRE.N), equity markets sagged, slumped and staged a short-lived rally on hopes a resolution was near.

But the weight of a credit crisis that has slowed world growth and threatened to push the U.S. economy into recession since a housing slump began more than a year ago reminded investors more pain than relief in the short term lay ahead.

Contributing to the pessimism was a $5 jump in oil prices to a new record above $147 a barrel on lingering worries over Iran's nuclear aspirations and a potential strike by Brazilian oil workers next week.

In fact, oil's rally could run further if Fannie and Freddie's troubles feed into the commodities boom by reducing the chances of a U.S. interest rate hike by the Federal Reserve.

Investors fear a protracted financial crisis would hit the already weak U.S. economy and markets. The U.S. stock market, bonds and the dollar all fell, with equities hit the hardest.

The blue-chip Dow at one point fell below 11,000 for the first time since July 2006. The Dow and broad market S&P 500 both closed down more than 1 percent.

Fears that Fannie and Freddie could require massive capital infusions also rattled investors in Europe where an index for the top 300 European shares closed at three-year lows and is now down 25 percent so far this year.

Gnawing at investor unease was a New York Times report that said the U.S. government was considering a takeover of Fannie and Freddie that could trim or eliminate the value of the mortgage companies' stock.

"The bottom line is that we're in the middle of a financial tsunami. This is a storm the likes of which this country hasn't seen," said Peter Kenny, managing director at Knight Equity Markets in Jersey City, New Jersey.

Wall Street opened weak and extended its losses after U.S. Treasury Secretary Henry Paulson said his department's chief aim is to back Fannie and Freddie in their "current form" -- comments that failed to soothe investor concerns.

The two government-sponsored entities, which hold more than $5 trillion in mortgage assets and were established to finance home ownership, are pillars of the U.S. economy.

U.S. Treasury prices slipped on fears a bailout would require a massive capital infusion and flood markets with more government debt. Yet the bonds of the two finance companies soared as investors bet the government would back their debt.

Sen. Chris Dodd, chairman of the Senate Banking Committee, said the Fed and the Treasury Department are considering opening the discount window to the two companies. "Both the Fed and the Treasury are looking at various options ... like the discount window," the Connecticut Democrat said.

The stock of the two companies fell to 50 percent of their day-earlier levels, but then cut their losses in half after Paulson played down the likelihood of a near-term bailout.