Ten Banks That Will Be Hurt by the Takeover of Fannie and Freddie

The government takeover of Fannie Mae (FNM) and Freddie Mac (FRE) should be a positive for most banks.  The deal will lower mortgage rates and will also allow the Treasury Department to purchase mortgage-backed securities from firms in the open market.  That will allow a lot of mortgage paper that is currently clogging the system to start moving again.  However, several banks will be hurt by the bailout of FNM and FRE because they own a considerable amount of FNM and FRE preferred equity relative to their capital bases. 

According to my math, the government will essentially own about 80% of FNM and FRE after the bailout.   The current preferred equity will no long pay a dividend until at least 2010.  While the preferreds have traded 45% to 65% lower already, they will most likely be completely wiped out from here.  If the companies can recover, there might be some value to the common and preferred equity in five to ten years.  However, as the companies enter run-off, my guess is that the common and preferred equity will not regain much value. 

Some banks such as Valley Financial (VLY) have already announced that they will take a charge for the decline in the value of their FNM and FRE preferred equity. From the Valley National press release:

In the second quarter of 2008, Valley National Bancorp ("Valley") disclosed that it holds Fannie Mae and Freddie Mac perpetual preferred stock with a cost basis of approximately $79 million. Such securities are held in Valley's available for sale securities portfolio and as such are subject to a potential other than temporary impairment charge. The estimated fair market value of these securities has declined from June 30, 2008 by approximately $40 million as of September 2, 2008, which if recognized would result in a $25.7 million after-tax impairment loss, or approximately $0.19 per fully diluted average common share for the third quarter of 2008. Valley sold a small portion of these securities during the third quarter, bringing its current adjusted cost basis in such securities to approximately $70 million. The aggregate amount of losses and other than temporary impairment that may be incurred on these securities during the third quarter of 2008 is difficult to determine, given the low trading volumes and the significant volatility in the market values of these securities. Based on management's current projections, a potential other than temporary impairment and loss on these securities would not impact its subsidiary bank's (Valley National Bank) ability to maintain capital ratios above the "well capitalized" regulatory requirement, or Valley's ability to pay its regular quarterly cash dividend to common shareholders.

Five banks have significant exposure to Government Sponsored Enterprise [GSE] equity that it could impact their capital ratios and force them to raise additional capital, according to Friedman Billings Ramsey's research.  The percentages in parentheses represents the percent of tangible capital is held in GSE preferred equity.  From Friedman Billings:

The top five exposures in our dataset by this metric were Gateway Financial Holdings (GBTS 8.1%), Midwest Banc Holdings (MBHI 26.3%), Financial Institutions, Inc (FISI 15.0%, based on securities collateralized by GSE preferreds), Westamerica Bancorporation (WABC 10.6%), and Sovereign Bancorp (SOV 8.9%). We have used an estimated after-tax exposure (using an assumed tax rate of 35% for all companies, for simplicity) in this analysis to improve the transparency of the relationships of these exposures to bank and thrift equity and capital, as unrealized gains or losses in these securities would only affect equity on an after-tax basis.

The next five banks on the list could also find themselves in need of additional capital after writing down the value of their GSE Equity exposure.  Flushing Financial Corp (FFIC - 7.5%), Valley National Bancorp (VLY - 6.5%), Astoria Financial Corporation (AF - 4.8%), East West Bancorp (EWBC - 4.1%) and Washington Federal (WFSL - 3.6%).

The full list of banks with material exposure to GSE preferred equity is listed below.  All data comes courtesy Friedman Billings Ramsey. 

(click to enlarge)

  Source: Friedman, Billings, & Ramsey & Co.

So while the majority of banks and financial stocks should rally on this news, several banks could be seriously hurt and even trade significantly lower. 

Comments

[madasiwannabe:]

The government has warrants, not stocks. The treasury has said they have no plan to exercise the warrants. What is the real book value? Exactly... no one knows. Until that's figured out, everyone is just speculating what will happen to both the common and preferred stocks.

Mortgage rates are tied to the 10 year T-bill. Current rate plus 2.5%. With the fed just maxing out the credit cards, the T-bill rate is going up not down. No good news for the markets here.

2008 Sep 08 07:52 AM

[Gerry Sullivan:]

This is good news for the markets, perhaps the critical piece. The common and preferreds will have some value and continue to trade.
I am a buyer when the preferreds hit my target price.
Currently no position, but looking at Fannie preferred S and T, the two sold at $25 within the last 12 months.

2008 Sep 08 08:18 AM

[GregY:]

I am tired of the government manipulating the markets, first browbeating the industry into ridiculous lending practices, and now not letting it to find a clear value. And that is done by "conservatively" minded government, what can we expect from the next one? They are turning the markets into another form of taxation. I am no longer putting any new money into this or vote Republicans.

2008 Sep 08 12:11 PM

[palsboss:]

I guess saving Lehman is next?


On Sep 08 12:11 PM GregY wrote:

> I am tired of the government manipulating the markets, first browbeating
> the industry into ridiculous lending practices, and now not letting
> it to find a clear value. And that is done by "conservatively&q....
> minded government, what can we expect from the next one? They are
> turning the markets into another form of taxation. I am no longer
> putting any new money into this or vote Republicans.

2008 Sep 08 12:49 PM

[Jackson Cash:]

All I can tell you is that the likelihood of uncle "sham" buying me a house is highly unlikely, so it should be with everyone else's!!!!! B.S.!

2008 Sep 08 01:26 PM

[Jason Rines...:]

Let me guess Syndicat, $2 :)

2008 Sep 08 06:25 PM

[freejack:]

ContraHour what are your thoguths on LM? They are invested big into FRE. Do you see them as a winner/loser and why?

Why is Bill Miller Increasing His Stake in Freddie Mac?
seekingalpha.com/artic...

Fannie, Freddie: The biggest losers
money.cnn.com/2008/09/.../

Bill Miller bets on Freddie Mac
dailybriefing.blogs.fo.../

Mean Street: Losing Faith in Freddie Mac and Bill Miller
blogs.wsj.com/deals/20.../

A humbling period for Bill Miller of Legg Mason
www.iht.com/articles/2...

Legg Mason's Miller still a 'long-term optimist' despite market turmoil
www.bizjournals.com/ba...

Mass. Pension Loses Trust In Legg Mason
www.forbes.com/2008/08...

Bill Miller bets on Freddie Mac
www.silobreaker.com/Do...

Who’s Afraid of Fannie and Freddie?
dealbook.blogs.nytimes.../

2008 Sep 08 06:39 PM

[Chris B:]

If mortgage debt is so toxic, and is currently trading at a fraction of its face value, then why not offer homeowners the option to buy their debt back at a fraction of the eventual cost to them? Then the banks get to sell their debt at market rates and homeowners who have the cash get the bargain of a lifetime. I would happily buy back my mortgage for 8% below the balance of the loan. With a 5.5% interest rate on my mortgage, and the tax deduction worthless to me because I take the standard deduction, that would amount to a 13.5% gain this year for me. Likewise, because the market value of my loan is probably 10% below the balance of the loan, the bank would improve its position by 2% and, more importantly, trade debt for badly needed cash.

Of course, the homeowners who were unable to take this option would be the ones more likely to default, but that would be the case independently of what the better-capitalized homeowners did. At least if the better-capitalized homeowners could buy out their mortgages, the banks would have cash to operate and pay for the inevitable defaults from the other homeowners.

2008 Sep 09 09:57 AM

[stock picks:]

I have a couple of CD's in Flushing Savings Bank. I hope that if something happens the government bails them out too. When does
the government step in for Lehman.

2008 Sep 09 06:36 PM

[YourBoss:]

GregY, if the government got us into all this mess, why would you vote for a party who represents a bigger government?


(GregY)
I am tired of the government manipulating the markets, first browbeating the industry into ridiculous lending practices, and now not letting it to find a clear value. And that is done by "conservatively&q.... minded government, what can we expect from the next one? They are turning the markets into another form of taxation. I am no longer putting any new money into this or vote Republicans.

2008 Sep 10 04:59 PM

[PeteK:]

GregY, same here, Why ?

2008 Oct 26 07:04 AM