Financials' foul Friday

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NEW YORK (CNNMoney.com) -- Anxiety over a possible government takeover of Fannie Mae and Freddie Mac sent financial stocks into a virtual tailspin Friday.

For the past several days, investors have feared that Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) - the government-sponsored backers of more than $5 trillion of home mortgages - face a possible collapse due to a lack of capital.

Those fears escalated on Friday as news reports claimed the Bush administration is considering a government takeover of one or both firms. Attempting to soothe investors, Treasury Secretary Henry Paulson said Friday morning that the government remains committed to "supporting Fannie Mae and Freddie Mac in their current form."

Shares of the mortgage finance giants endured a volatile Friday, but both stocks, as well as those of other financial companies, finished in negative territory by the session's close.

"Fannie and Freddie are indicative of how the financial sector is performing," said Jeffrey Davis, an FTN Midwest Research bank analyst. "Their meltdown is just another symptom that financials are in trouble."

The news regarding Fannie and Freddie heightened investors' fears about the continuing credit crisis. If the companies were unable to guarantee the mortgages they purchased, it would raise the cost and restrict the availability of home loans, causing significantly more problems for the already-battered housing market.

This sent financial stocks - particularly companies tied to the mortgage business - into a nosedive, because investors worried that financial institutions' assets backed by residential mortgages could be further devalued.

"For financial firms that own mortgage-backed securities, if the underlying real estate is defaulting, that puts more pressure on the system," Davis said.

Mortgage insurers. Shares of three of the largest mortgage insurers, PMI Group Inc. (PMI), MGIC Investment Corp. (MTG) and Radian Group Inc. (RDN), slumped 15.3%, 19.9% and 25.1%, respectively.

Mortgage insurers, which help many consumers afford homes, have been hit particularly hard in recent weeks as the housing market continues to further deteriorate and signs of trouble mount for the broader U.S. economy.

"Mortgage insurers are not well diversified and highly leveraged," said Davis. "To the extent that Fannie and Freddie facilitated liquidity and grew other institutions' balance sheets, if the mortgage assets melt down, there's no way that financials aren't going to be hit."

Banks. Banks didn't fare much better. Wachovia (WB, Fortune 500) tumbled 12.1%, Washington Mutual (WM, Fortune 500) shed 5.7%, JPMorgan Chase (JPM, Fortune 500) lost 3.9% and Wells Fargo (WFC, Fortune 500) dipped 2.6%.

Bank of America (BAC, Fortune 500), which just completed its acquisition of Countrywide Financial - making it the nation's largest mortgage lender - slid 3.1%.

"For the challenges that banks are facing today, the theme really is residential property," said Terry McEvoy, an analyst with Oppenheimer & Co. "Since 70% of mortgages are connected to Fannie and Freddie, today's news just reinforces the problems that the banks are facing."

Even Citigroup (C, Fortune 500), which sold its German retail banking unit for $7.7 billion, could not pull out of negative territory Friday, slipping 0.6%.

Bond insurers. Other areas of the financial sector that have been hit hard by the continuing credit crisis also took a plunge Friday. Bond insurer MBIA (MBI) fell by 7.1%. Ambac (ABK), which traded down more than 10% earlier in the day, closed up 6.8% after announcing later in the day it is insuring a $264 million privatization of 3,500 Air Force housing units.

Investment banks. Lehman Brothers (LEH, Fortune 500) tumbled 16.6%, after the Wall Street firm provided more details about last quarter's nearly $3 billion loss. Goldman Sachs (GS, Fortune 500) and Merrill Lynch (MER, Fortune 500) followed suit, with losses of 4.5% and 3.8%.