A deteriorating balance sheet, combined with dramatically increased risk exposure, could spell disaster for both Fannie Mae (NYSE: FNM) and the entire financial system.

On Tuesday, Fannie Mae announced worse-than-expected earnings, with billions in loan losses and a plan to raise capital through an equity offering and a dividend cut. How unusual.

How bad was it?
The mortgage giant reported a first-quarter loss of $2.2 billion, or $2.57 per share, versus a gain of $961 million or $0.85 per share in the same quarter last year. This was way short of the Thomson Financial average analyst estimate of a loss of only $0.81 per share. In addition, Fannie Mae announced $4.4 billion in fair-value losses and $3.2 billion combined for credit loss provisions and expenses related to foreclosures.

As a result, the company announced plans to shore up its capital position with a $6 billion equity offering and a dividend cut. This action nicely complements the $7 billion capital-raising and 30% dividend cut undergone last December.

These days, for large financial companies -- such as Citigroup (NYSE: C), Wachovia (NYSE: WB), Merrill Lynch (NYSE: MER), and UBS (NYSE: UBS) -- losing billions is as commonplace as rock stars with drug problems. However, Fannie's situation is uniquely treacherous, because the company is simultaneously and dramatically increasing its risk exposure.

How is Fannie more at risk?
In the midst of the credit crunch, the government has looked to both Fannie Mae and Freddie Mac (NYSE: FRE), as the nation's primary buyers of mortgages in the secondary market, to increase their roles and restore stability to the system. In doing so, government regulators have said they'll decrease Fannie Mae's required capital cushion from 20% of total mortgage debt to 15%, after the $6 billion infusion.

The mortgage giants have been the industry's only lubricant, since Wall Street has run away from such investments. In the first quarter of this year, the companies handled 80% of the mortgages bought by investors in this country. That's more than double the amount they handled as recently as 2006.

Can the mortgage giants handle it?
At the same time, Fannie reports that assets on its balance sheet are rapidly losing value in the current market. In addition, Fannie forecasts that things will continue to get worse. It expects home prices to fall 7%-9% this year and credit losses to worsen in 2009.

Regulators currently require that Fannie and Freddie have a combined capital cushion of $83 billion. This represents the only safety net for combined portfolios of $5 trillion in debt and other commitments.

What could happen?
Increased roles for Fannie and Freddie could be just what the doctor ordered to maintain confidence and liquidity in the mortgage markets at a crucial time and stave off a far greater crisis. However, if the crisis continues to deepen, these companies could go under and possibly push the worldwide financial system into turmoil.

William Poole, a former Federal Reserve Bank president, said that Fannie and Freddie are "at the top of my list of sources of potentially serious trouble." And according to Senator Mel Martinez, a former secretary of housing and urban development, the companies "could cause an economywide meltdown if they got into real trouble and leave the public on the hook for billions."

For more Foolishness:

Fool contributor Tom Hutchinson holds no financial position in any companies mentioned. The Motley Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.