As the crisis worsens for mortgage giants Fannie Mae and Freddie Mac, Treasury Secretary Henry Paulson is insisting that any potential government rescue plan not benefit the companies' shareholders, according to people familiar with the matter.

The two stockholder-owned, government-sponsored companies, whose operations are vital to the functioning of the U.S. housing market, faced a severe crisis of confidence after a week in which their stocks each lost nearly half their value. On Friday, Freddie Mac finished the day at $7.75 a share, and Fannie Mae at $10.25.

The discussions at Treasury highlight the dilemma created by the financial crisis gripping the U.S: Some institutions are considered too big to fail, but propping them up could erode the market's incentive to properly judge risk by offering investors a false sense of security.

After a week of near panic among shareholders of the two companies -- and a stomach-churning day on Wall Street Friday -- the next big test will come Monday when Freddie Mac is due to sell $3 billion of short-term debt. An unsuccessful sale could be a major blow to investor confidence. If the administration were to intervene, it could do so before markets opened that day, according to a person familiar with the deliberations.

The companies' weakened state is a new and unwelcome headache for Wall Street's top banks and securities firms, already battered by a year's worth of debt-related losses. The financial firms hold mortgage securities guaranteed by Fannie Mae and Freddie Mac as well as debt issued by the companies to fund their operations. Some also earn fees from underwriting those securities.

How any rescue might be orchestrated remains unclear. The administration doesn't expect the firms to fail and it is "not talking about nationalizing" the struggling mortgage giants, according to a person familiar with its thinking. Mr. Paulson issued a written statement Friday saying that the administration's "primary focus is supporting Fannie Mae and Freddie Mac in their current form."

One option would have the government buy a chunk of Fannie and Freddie's preferred stock with terms that dilute the equity of common shareholders. The Federal Reserve could support Fannie Mae or Freddie Mac in a short-term funding crisis through its lending operations, which were extended to investment banks in March with the downfall of Bear Stearns Cos. A spokeswoman said Friday the Fed hasn't discussed that possibility with either company.

Getty Images President George W. Bush met on energy prices with members of his economic team in Washington, D.C., Friday.

High Anxiety

Monday's auction comes at a time of huge anxiety. Fannie and Freddie sell tens of billions of dollars of short- and long-term debt each month and use the proceeds to finance their purchases of mortgages from banks. If they were unable to replace maturing debt for an extended period, they would have to stop buying mortgages and eventually sell home loans and securities they hold in their portfolios. That would be likely to send consumer mortgage interest rates soaring.

"I think the auction will go reasonably well," said Ira Jersey, an interest-rate strategist at Credit Suisse in New York. Several investment banks contacted Friday said they will participate in the auction.

Others were more cautious. "We've been seeing a lack of buyers for [short-term notes from Fannie and Freddie] because of uncertainty about whether there's going to be an explicit government guarantee behind the debt," said Benjamin Cheng, an interest rates strategist at UBS AG. "If there isn't more clarity on that by Monday, that auction could be ugly," he added.

Longer-dated bonds of Fannie and Freddie, on the other hand, saw heavy buying on Friday. Their yields relative to Treasury securities fell, suggesting the companies' longer-term borrowing costs should stay relatively low as debt investors are still comfortable about the outlook.

Investors believe that both companies will have to raise large amounts of capital to cope with the losses they face on mortgage defaults. Freddie has announced plans to raise $5.5 billion through a share offering but finds the market for its stock extremely weak. On Friday, Freddie said it doesn't need to raise capital in the "near term." The company said its second-quarter results, due to be released early in August, will show that it has capital well above the minimum imposed by its regulator.

Fannie also sought to reassure the markets Friday. "We are maintaining a strong capital base, building reserves for our credit losses, and generating solid revenues," the company said. Fannie said it sold more than $24 billion in debt in the past week.

Shares in the two companies -- which own or guarantee about $5 trillion of mortgages or nearly half of all U.S. home-mortgage debt outstanding -- have plunged during a wild week. Both stocks are at their lowest closing levels in more than 16 years. With few respites, they plummeted all week as investors grew more and more fearful that the companies' need to raise more capital would dilute or even wipe out the value of existing shares. Investors also reacted to gloomy talk, such as the comment from a former Federal Reserve official that Fannie and Freddie were "technically insolvent," a statement denied by both companies.

On Friday, major indexes were all over the place, ending a roller-coaster session in negative territory. After spending most of the session deep in the red, an erroneous report suggesting the Fed would allow Fannie and Freddie to borrow money from the central bank caused a dramatic reversal. Major indexes moved into positive territory, but the rally faded.

The Dow Jones Industrial Average fell 128.48 points, or 1.1%, to close at 11,100.54 after earlier falling below 11,000 for the first time since June 2006.

Freddie Mac finished the day lower by 3.1%, and Fannie Mae lost 22%. Respectively, Fannie and Freddie saw 405 million and 394 million shares change hands in trading Friday, compared with average daily volume of 19.6 million and 15.3 million shares over the past 52 weeks.

Investors are worried the firms will suffer more losses as mortgage defaults rise. Stock-market investors are also worried the companies will need to raise significant amounts of capital to cover those losses. For investors, that means the value of their ownership stakes in the company will be cut. Bond investors continue to lend to both companies, though they are also demanding slightly higher interest rates.

Moral Hazard

If a rescue becomes necessary, Mr. Paulson does not want to help the shareholders because of the "moral hazard" it would create -- desensitizing investors to risk because they believe the government will bail them out. It's a similar position he took during the government-orchestrated rescue of Bear Stearns by J.P. Morgan Chase & Co.

Growth Fund of America from American Funds, part of Capital Research & Management Co., was recently the mutual fund with the most Fannie Mae stock, holding more than 50 million shares. Other big holders have included AllianceBernstein Holding LP and Fidelity Investments. Growth Fund of America has also been the biggest fund holder of Freddie Mac, recently holding more than 25 million shares, followed by funds like Bill Miller's Legg Mason Value Trust. The firms declined comment.

The crisis has been exacerbated by the strange hybrid nature of the two companies, which have prospered because they are seen as having the implicit backing of the U.S. government. Chartered by Congress to ensure a steady flow of money into housing finance, they can borrow cheaply because investors believe the government probably would rescue them in a crisis. Yet they are owned by private shareholders who want profit growth and dividends.

The implicit guarantee has allowed the companies to borrow at lower rates and buy more mortgages, providing a benefit to shareholders. There's a belief among many politicians and officials that it is the shareholders -- not taxpayers -- who should bear those risks because they benefited greatly in the past from the implied government backing.

The government has increasingly leaned on the so-called government-sponsored enterprises to provide stability to a housing market crippled by falling home prices and banks too nervous to lend.

"Do a little examination and ask yourself, 'What do you think the housing market in the U.S. would look like without the GSEs now?"' Richard Syron, Freddie's chairman and chief executive, said earlier this year.

The Bush administration has long worried about the systemic risk posed by the companies. The administration has pushed for a regulatory revamp, including a new, more powerful regulator to oversee them. Long-awaited legislation that would do that passed the Senate on Friday.

Freddie said it is looking at options to conserve capital. The company holds about $770 billion of mortgage loans and related securities. That produces repayments of around $10 billion a month as homeowners pay off their loans. Normally, Freddie reinvests that money in new mortgages. But if it stops buying mortgages, it has less need for capital. Not replacing mortgages that pay off would "free up approximately $250 million of capital per month," Freddie said.

There's a political downside: By putting on the brakes, Freddie would be providing less support to an already weak market.

Freddie also said it "could consider reducing our common stock dividend" of 25 cents a share. Eliminating that dividend would save nearly $650 million a year.

There are signs that Fannie and Freddie may have to pay modestly higher rates for short-term borrowings. Fannie and Freddie's previously issued three-month notes traded Friday at a yield of about 2.43%, up from the 2.34% paid at Fannie's auction of such notes Wednesday, traders said.

Freddie has total debt outstanding of $874 billion, of which 27% is short-term. In addition, the company owns or guarantees about $2.2 trillion of mortgages. Fannie's debt outstanding is $782 billion, of which 29% is short-term. Fannie owns or guarantees about $3 trillion of mortgages.

Risk for Wall Street

Wall Street could be exposed. David Trone, who follows financial stocks at Fox-Pitt, Kelton, estimated that Citigroup Inc. had $36 billion in mortgage securities backed by the companies and $15 billion in debt issued by them, and J.P. Morgan, $65 billion and $22 billion. Both companies declined to comment.

Stock analyst Matthew Albrecht of Standard & Poor's Corp. noted that Wall Street also faces the risk of a reduction in fees for mortgage underwriting, an area of relative strength. Fees for mortgage debt backed by Fannie and Freddie, and their securities, which totaled $952 million in 2007, have already topped $550 million this year, according to Thomson Reuters, which tracks new issues.

On Friday, some market participants said investors were trying to unload Fannie and Freddie's short-term discount notes, but few people were willing to purchase them at levels that sellers were asking.

--Randall Smith, Damian Paletta and Sudeep Reddy contributed to this article.

Write to Serena Ng at serena.ng@wsj.com

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