Why Do Regional Banks Hold Fannie and Freddie Preferreds?

I just saw this, from the FT:

Regional banks, together with US insurers, hold the majority of Fannie and Freddie's $36bn of outstanding preferred stock, which could be wiped out in the event of a government rescue.

This is creating some bickering between Treasury and the Fed, according to John Carney, with the Fed worried that an aggressive recapitalization of Fannie and Freddie could have nasty systemic consequences if the brunt of the hit was borne by regional banks.

But here's my question: What on earth were these regional banks doing holding the GSEs' preferred stock in the first place? Senior debt I could understand, but this is equity, at least from a regulatory perspective. And when they bought it, I doubt it was yielding much more than their own cost of funds. It all makes very little sense to me -- which of course is par for the course, in this credit crunch.

If we've learned one thing over and over again this past year, it's that the financial system often behaves in bizarre and seemingly illogical ways. At some point, a "reversion-to-making-sense" trade will start becoming profitable. But if you're marking to market, be warned: there might well be a lot of downside yet to come.

Comments

[taxbaby:]

see the excellent Bloomberg article,
www.bloomberg.com/apps... which states in part,

Banks bought Freddie and Fannie preferred stock because they can be used as capital that regulators require to cushion against losses on loans. Banks also get a tax break on 70 percent of the securities, making them attractive to own, said Midwest's Wiest.

``These are the only two companies that the regulators have allowed banks to hold in their portfolios,' Wiest said. ``Everybody knows we have them. It seems like every bank has them.''

Today, Lehman noted the following recent disclosures of
preferred GSE stock holdings:
JPM ($1.2 bln), FITB ($55 mln), MTB ($162 mln), and USB ($79 mln).

The Bloomberg article says Sovereign Bank holds $632 mln.

2008 Aug 26 11:52 AM

[buyitcheap:]

Every bank does have them - as cash equivalents. You ask the exactly right question and the answer I'm betting is NO they have not been marked down.

2008 Aug 26 12:21 PM

[DTLRM:]

1) With the 70% dividend reduction deduction for Federal Income Taxes purposes, a holder can "gross-up" the effective after tax yield on the securities; i.e. enhance the total after tax yield for the entire net interest margin. Likely to be many banks highest yielding assets.
2) These equities are permissible by regulatory guidelines.
3) The focus in the markets is on the holdings at pubic banks, how about the holdings at private banks?
4) If Fannie or Freddie failed and the common and preferred stock was valued at zero, how much additional stress would the Fed, FDIC and the markets have on their hands? Could impair many banks ability to remain solvent.

2008 Aug 26 01:42 PM

[buyitcheap:]

DTL - Your last sentence in item 4 is probably why they will "guarantee" the common stock for FRE and FNM - just an quick look at some of the balance sheets of banks around my area (albeit small sample), seem to show that they would quickly approach the edge of solvency. They own a lot of this @!#($. And the worst part is, looking at earlier 10Qs some of them were buying on the way down and likely have bases in their holdings north of $30/share. eeek.

2008 Aug 26 01:51 PM