Both U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke were called to the carpet yesterday (Tuesday) to explain to Congress how continued turbulence in U.S. credit markets will affect the economy in coming months.

Both ended up backtracking on previous statements, as their ill-conceived cures for the broader U.S. economy were stripped of any relevancy by a tumultuous and unforgiving credit market.

Fannie Mae (FNM) dropped $2.13 a share, or 22% yesterday, to close at $7.60 share. Freddie Mac (FRE) sank $1.77, or 25%, to close at $5.34 a share. The beleaguered mortgage giants dragged the market down with them, as the Dow Jones Industrial Average closed down 92 points, or .84% at 10,962.54. It had earlier fallen as low as 10,840.81. The S&P 500 Index closed at 1,214.91 down 13 points, or 1%.

After saying Sunday that Fannie Mae and Freddie Mac “play a central role in our housing finance system and must continue to do so,” Paulson amended his comments to the Senate Banking Committee, saying his plan “is aimed at supporting the stability of financial markets, not just these two companies.”

“Let me stress that there are no immediate plans to access either the proposed liquidity or the proposed capital backstop,” Paulson added. “If either authority is used, it would be done so only at Treasury’s discretion, under terms and conditions that protect the U.S. taxpayer.”

Similarly, Federal Reserve Chairman Ben S. Bernanke was forced to rethink his previous statements concerning the progress of the economy.

After saying in June that the risks of a “substantial downturn” had diminished and the Fed would shift its focus to resisting “an erosion of longer-term inflation expectations,” Bernanke said before Congress today, that the economy “continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil [and] food.”

Now, as credit markets tighten and inflation continues to strengthen its grip on the U.S. economy, both Paulson and Bernanke have the unenviable task of shepherding the economy through one of the most difficult economic climates of the past century.

Paulson’s Predicament

After opening higher Monday following Paulson’s remarks and a successful sale of short-term debt at Freddie, both stocks resumed their slide with each company falling more than 30% in the past two days. Fannie Mae has lost 81% year-to-date, while Freddie Mac has dropped 84.5%.

“The impact of Sunday’s announcement by the Federal Reserve regarding its mortgage bail-out plan for Fannie Mae and Freddie Mac remains somewhat derided in the market,” James Hughes at CMC Markets told the Financial Times. ”It has apparently done little more than underline the perilous state of the U.S. economy.”

Both Freddie and Fannie have cash on hand, and both meet their regulatory capital requirements. It also looks as though both firms will also be bolstered by U.S. Treasury Secretary Henry Paulson’s rescue plan, which includes generous credit lines and a pledge by the U.S. government to purchase equity in the companies as needed.

But government assistance notwithstanding, investors and analysts anticipate falling house prices and an increasing number of mortgage defaults will incinerate what little capital the companies have left. Their balance sheets are also highly suspect, though Freddie Mac looks far worse off than Fannie Mae.

At the end of the first quarter Freddie’s balance sheet showed assets of $803 billion and shareholder equity of just $16 billion, CNNMoney reported. That means Freddie has just one dollar in equity for every $50 of mortgages and other assets it holds. The company’s mortgage portfolio is even more disconcerting, as it shows just 70 cents worth of equity for every $100 worth of business on its books.

“Is this enough equity when your business consists of buying and guaranteeing mortgages?” Len Blum, a managing director at New York investment bank Westwood Capital, wrote in a recent report quoted by CNN. “How about when you conduct these activities in markets falling by 20% or more?”

Finally, according to the fair-value balance sheet, which reflects the value of Freddie’s assets rather than their cost, the company’s shareholder equity stands at negative $5.2 billion. Using fair-value accounting, Fannie Mae shareholders are still up $12 billion.

Also, as other lenders have withdrawn from the mortgage market in the face of plummeting home values and a mountain of foreclosure filings Fannie and Freddie have been left to pick up the slack to the point that they are now involved in 80% of U.S. mortgages.

With so much on the line, the failure of Freddie Mac and Fannie Mae would be cataclysmic. And not just for the U.S. market, but for global investors.

Because government-sponsored enterprises (GSEs), such as Fannie and Freddie, offer higher yields than treasuries and enjoy implicit assurances from the U.S. government, they are very appealing to foreign investors who hold approximately $1 trillion in GSE debt.

Indeed, if Fannie and Freddie were to fail, it would undermine these investments and cost international investors dearly.

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