President Bush was forced yesterday to wade into the turmoil surrounding the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corporation (Freddie Mac) which underpin America’s entire debt infrastructure, saying that his two leading economic lieutenants – Henry Paulson and Ben Bernanke – were “working this issue very hard”.

Fannie’s shares dived 50 per cent and Freddie’s 48 per cent in midday trading as investors fretted that the Government was making covert preparations to support them and would render their stock worthless.

The shares did regain some lost ground, as it emerged that Mr Bernanke, the US treasury secretary, was seriously considering extending his central bank’s “discount window” of cheap financing to the two groups to help plug their balance sheet gaps, as an alternative to backing them.

Speaking after a meeting with his economic team, President Bush said that “Freddie Mac and Fannie Mae are very important institutions”, adding that he had spoken with Mr Paulson, the Treasury Secretary, who had “assured me that he and Ben Bernanke [the Federal Reserve chairman] will be working this issue very hard”.

Although the US Government is preparing to rescue Freddie and Fannie if necessary, it is thought to be keen to avoid such action if it can. Mr Paulson attempted to steer investors away from the notion of a rescue by saying that his preference was for Fannie and Freddie to continue “in their current form”. However, he failed to explicitly rule out the possibility of government backing if the situation continued to deteriorate.

The increasingly poor outlook for the American mortgage market pushed down shares in other groups with a large stake in the fortunes of the housing industry. Lehman Brothers was among the worst hit, with the group’s shares falling by 20 per cent at one point, before it recovered slightly to end 16.6 per cent down at $14.43.

A $5 rise in the price of a barrel of New York crude oil, to breach $147 for the first time, rattled investors further. This helped to push the Dow Jones – already in bear territory after a decline of more than 20 per cent since its last peak in October – to below 11,000 for the first time since July 2006. The Dow went on to close down 128.50 at 11,100.50.

The possibility that Fannie and Freddie could access the discount window briefly reassured the market, prompting a rally that was short-lived as fears about the outlook for the housing market, and the damage it could inflict on the broader economy, “quickly returned to spook investors”. Fannie Mae closed 21.70 per cent lower at $21.97 and Freddie Mac ended the day at $7.75, a loss of 3 per cent.

Fannie and Freddie are a crucial component in the housing industry, and the debt markets in general, because they buy mortgages, package most of them into bonds and sell them on to investors, which they guarantee. They collectively own or guarantee more than half of America’s $12,000 billion outstanding mortgages and their failure would have a domino effect that analysts say would decimate the debt markets and, in turn, the US and global economy.

Chris Whalen, of Institutional Risk Analytics, added: “If people thought for a moment that the US central bank would not ultimately stand behind Fannie and Freddie then the entire US financial system would collapse.”

Mr Whalen forecasts that the US Government will eventually renationalise both groups and merge them. The combined entity would find it easier to raise the money needed to fund the tens of billions of dollars of losses they are collectively expected to suffer from the credit crunch if it had the backing of the taxpayer, Mr Whalen said.

Even if the Government does not end up rescuing Freddie and Fannie, their shareholders feel doomed. Analysts believe that the two enterprises are so thinly capitalised that they could not possibly raise the capital they need to survive if they continue as public companies.

— London’s shares suffered another big sell-off. The FTSE 100 index tumbled 145.2 points, or 2.7 per cent, to close at 5,261.6, its lowest since October 2005. It is now more than 20 per cent below its most recent peak in June last year and therefore officially a bear market.

Times Recommends

• C&G axed - 1,660 jobs to be lost
• UK house prices rise 1.1% as buyers return
• Mixed reaction to US banks repaying bailouts