WASHINGTON (Reuters) - U.S. officials sought to quell concerns on Tuesday that rescuing Fannie Mae and Freddie Mac would amount to a blank check signed by taxpayers, while investors dumped shares of the mortgage finance companies amid fresh worries over their financial health.
U.S. Treasury Secretary Henry Paulson, who orchestrated Sunday's plan to bolster Fannie and Freddie, said the pledge to extend more credit or buy stakes in the companies was designed to be a backstop. The government had no intention of investing public funds in the mortgage companies right now, he said.
At a hastily organized Senate Banking Committee hearing, where Paulson appeared alongside Federal Reserve Chairman Ben Bernanke and Securities and Exchange Commission Chairman Christopher Cox, tensions flared as members of Congress deplored the potential risks to taxpayers should Fannie and Freddie deteriorate further.
"I think you could be risking the taxpayer's dollar here," said Sen. Richard Shelby, the top-ranking Republican on the committee. Shelby said Congress would need to consult with Treasury before signing off on a "blank check".
The SEC also announced that it would issue an emergency rule to stop some forms of short selling in major financial firms, including Fannie and Freddie, which have lost about half their value since the start of last week.
Short sellers borrow shares that they consider overvalued and sell them. If the price drops, they repurchase the shares, return them, and pocket the difference. In a "naked" short sale, the type the SEC now wants to curb, the investor sells stock that has not yet been borrowed.
Fannie FNM.N and Freddie FRE.N shares fell more than 25 percent, hurt by concerns over how shareholders would fare should the government take over the companies. A credit rating agency cut their financial strength ratings, adding to fears.
There was also less demand for the companies' debt even though investors say the proposed rescue favors creditors.
Acute fears lingered about the future of the two mortgage finance firms, which have reported a combined $11 billion in losses during the past year as the housing market worsened.
"They are far from well-capitalized," William Ackman, who runs the Pershing Square Capital Management hedge fund, told CNBC television. "These institutions need to be able to withstand the perfect storm. It is now the perfect storm."
The Treasury Department has asked Congress to approve an unlimited, temporary line of credit to Fannie and Freddie. Paulson said he was seeking an open-ended amount in the hope that the credit lines would never need to be tapped.
"If you've got a squirt gun in your pocket, you may have to take it out. If you've got a bazooka and people know you've got it ... you're not likely to take it out," Paulson said. "By having something that's unspecified, it will increase confidence and by increasing confidence it will greatly reduce the likelihood it will ever be used."
Paulson pointed out that Treasury could refuse to extend credit to Fannie and Freddie, or set conditions on any borrowing to ensure that taxpayer money was safeguarded.
While investors initially welcomed the plan to increase credit lines or buy equity stakes in Fannie and Freddie, they have since soured on the two companies. Sentiment was damaged further when Moody's Investors Service cut the preferred stock and bank financial strength ratings of both and said it may cut them again.
Some members of Congress clearly had their doubts as well.
Paulson sparred with Sen. Jim Bunning, a Kentucky Republican, over whether the government could be trusted on assurances that the credit line would not be used.
"You really think we can believe exactly what you're saying, Secretary Paulson?" Bunning asked. Paulson replied, "I believe everything I say and I've been around markets for a long time."
Republican leaders of the U.S. House of Representatives called for full hearings on the proposed rescue, a move that could slow down congressional action on a housing rescue bill.
U.S. President George W. Bush said on Tuesday that Fannie Mae and Freddie Mac must be able to continue providing access to credit and that they should remain owned by shareholders.
"We have advocated reform for a long period of time," Bush said of the two companies. "But these need to remain private enterprises, and that's what our message is."
SEC's Cox acknowledged that the way Fannie and Freddie are set up -- publicly traded stocks but with an implicit government guarantee -- was problematic.
"I think the combination of socialized risk and privatized profit is a very suspect model," he said.
Fannie Mae shares ended the trading session down 27 percent at $7.07. Freddie dropped 26 percent to $5.26.
Additional reporting by Steven C. Johnson, Lynn Adler, Ellis Mnyandu, Karen Brettell and Anastasija Johnson in New York, Jeremy Pelofsky, Lisa Lambert, Rachelle Younglai, David Lawder, Mark Felsenthal and Deborah Charles in Washington and Svea Herbst-Bayliss in Boston; Editing by Andrea Ricci