Why Do Regional Banks Hold Fannie and Freddie Preferreds?

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Includes: FMCC, FNMA, KRE
by: Felix Salmon

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.