The Treasury Department’s bailout of Fannie Mae and Freddie Mac could ignite a cascade of sizable writedowns and losses at up to 40 banks around the country, analysts say.
The reason is the Treasury did not adopt in its rescue of Fannie Mae (FNM: 0.99, +0.26, +35.61%) and Freddie Mac (FRE: 0.88, +0.07, +8.64%) a plan that would protect the value of the preferred shares, or the common stock, in the two mortgage giants.
Fannie and Freddie own or guarantee about $5.4 tn in home loans–half the nation’s total, and half the size of the US gross domestic product. Preferred shares are different than common stock, as they carry no voting rights, among other things.
As a result, the Treasury Department’s plan now threatens to blow open gaping potholes in dozens of bank balance sheets due to the resulting drops in value in Fannie and Freddie preferred shares.
Because of the bailout, the preferred stock in Fannie and Freddie could eventually be worth just pennies on the dollar, or even zero, according to some analysts.
And because of the looming losses, the regionals will be forced to either go hat in hand to, say, the private equity crowd, consolidate, merge, or go out of business–or, ironically, raise capital via more preferred share offerings.
The potential write-downs and losses come after the Treasury Department and the Federal Housing Finance Agency seized control of the mortgage giants, in what is expected to be the world’s biggest government bailout that effectively makes the US government the planet’s largest mortgage finance company.
Dozens of Banks Hurt
Anywhere from 25 to 30 regional banks who own their preferred shares will be hurt by the Treasury plan, government banking sources say. Wall Street firms say the number is larger. Big banks including JPMorgan Chase (JPM: 39.47, -2.08, -5.00%) and Wells Fargo (WFC: 31.17, -2.39, -7.12%) could be hurt.
Some banks could be battered hard. Losses from Fannie and Freddie preferred stock holdings at Sovereign Bancorp (SOV: 8.70, -0.32, -3.54%) could wipe out up to a year’s worth of profit at the bank, analysts at CreditSights estimate.
A research note from Keefe, Bruyette & Woods identified 38 regional banks, mostly smaller outfits, potentially hurt by the plan. Goldman Sachs says up to 40 banks and financial firms will be hurt. At least eight banks had more than 10% of their capital tied up in the shares, while another six had between 5% and 9%. It’s estimated that $36 bn in preferred holdings in Fannie and Freddie sit on bank balance sheets around the country.
The Federal Deposit Insurance Corp. now has on its watch list 117 problem banks and thrifts, the highest level since the middle of 2003. That’s up from 61 in the year ago period and 90 in the first quarter. The 11th bank of the year, Silver State, failed last week.
The Treasury’s Double Whammy
Many banks included Fannie’s and Freddie’s preferred shares’ dividend stream in their profit figures, and separately, included the shares in their statutory capital cushions required by bank regulators.
The Treasury’s new rescue plan presents a double whammy to the regionals. First, it wipes out the dividends on the preferred shares in Fannie and Freddie. Second, it batters their already slammed preferred shares, which the regional banks included in regulatory capital cushions.
Stocks in the regional banks could plunge even more, as they no longer can report the dividends in profits and as it could leave them without the required capital levels.
Treasury Admits the Problem
Government officials acknowledged the risks from their plans to the regionals on Sunday. “While many institutions hold common or preferred shares of these two GSEs [government-sponsored enterprises, or Fannie Mae and Freddie Mac], a limited number of smaller institutions have holdings that are significant compared to their capital,” Treasury Secretary Henry Paulson said in a statement.
The government is reportedly coming up with a plan to take care of the banks’ capital shortfalls as their preferred holdings potentially get zeroed out, but so far no details have come to light.
The Treasury did not state whether the subsequent losses at the regionals triggered by its plan would result in the takeover of troubled banks by other institutions.
Who Gets Hurt
Wells Fargo, (WFC: 31.17, -2.39, -7.12%), the nation’s fourth-largest bank by stock market value, said it will take a third-quarter write-down on its preferred securities in Fannie Mae and Freddie Mac.
Meredith Whitney, a widely followed banking and brokerage analyst at Oppenheimer Equity Research, estimates that Wells Fargo will report an after-tax charge in its third quarter of $281 mn to $297 mn, or 9 cents per share.
JPMorgan Chase (JPM: 39.47, -2.08, -5.00%), the country’s second largest bank in terms of assets, already said it expects to take a $600 mn loss on its preferred shares in its third quarter, half of its $1.2 bn preferred share stake in Fannie and Freddie.
M&T Bank (MTB: 74.56, -1.44, -1.89%) owns an estimated $120 mn in Fannie’s and Freddie’s preferreds, Fifth Third Bancorp (FITB: 15.93, -0.97, -5.73%) owns an estimated $55 mn, and National City (NCC: 4.76, -0.39, -7.57%) owns an estimated $10 mn.
Also vulnerable are Gateway Financial Holdings (GBTS: 5.00, -0.35, -6.54%), Midwest Banc Holdings (MBHI: 4.18, -0.30, -6.69%), Farmers Capital Bank Corp. (FFKT: 26.31, -2.12, -7.45%) and Westamerica Bancorp (WABC: 54.20, -0.54, -0.98%).
E-Trade Financial Corp. (ETFC: 3.18, -0.26, -7.55%) and American International Group (AIG: 18.37, -4.39, -19.28%) also own preferred shares in Fannie and Freddie as well.
Among the banks with the greatest exposure to the preferred shares of Fannie and Freddie is Sovereign Bancorp (SOV: 8.70, -0.32, -3.54%), which held $623 mn in preferred shares or about 9% of its tangible capital, according to the research firm Keefe, Bruyette & Woods.
Sovereign recently raised $1.9 bn in capital to shore up a balance sheet battered by credit losses. “In the event that Sovereign was required to write off this entire investment, and was not able to record a tax benefit for the loss, Sovereign’s capital levels would still exceed the levels required to be considered well-capitalized,” the bank said in a regulatory filing.
How the Plan Wipes out the Preferreds
Under the Treasury’s plan, dividends on both common and preferred shares in Freddie and Fannie will be eliminated, saving about $2 bn per year. The Treasury is also buying $1 bn of senior preferred stock in each company that include a 10% dividend yield and the right to buy 79.9% of the common shares at less than $1 a share.
Under the new regime, the preferred shareholders are second in line behind existing common shares to absorb any losses at Fannie and Freddie.
As a result, preferred shares in Fannie and Freddie have plunged in value, as Moody’s and S&P have slashed their ratings now veering towards junk status. The benchmark Freddie Mac Series Z preferreds now trade at about $2.50, and Fannie’s Series S preferreds trade at around $2.04.
Treasury’s Hobson’s Choice
Letting the existing preferred shares drop in value are among the tough choices being made. Treasury’s rescue plan protects Freddie and Fannie’s mortgage-backed securities instead of the equity holdings in Freddie and Fannie, in order to appease central banks and commercial banks around the globe.
The dollar amount of Fannie and Freddie’s senior mortgage-backed debt obligations that the two hold on their own books now approaches about $1.5 tn.
The two have also guaranteed about trillions of dollars in mortgage-backed securities scattered around the globe, in portfolios held by central banks and other institutions around the world. Central banks have threatened a buyer’s strike unless Treasury explicitly guaranteed new issues from Fannie and Freddie, economist Edward Yardeni notes. Central banks overseas have cut their holdings in Fannie and Freddie debt securities by $18 bn sine July 15.
According to CreditSights, the majority of US banks own sizable holdings in their mortgage-backed securities, on average about 50% of the total securities portfolio for most banks.
That compares to the $36 bn in preferreds owned by the regionals and other banks. Zeroing out the common and the preferreds and preserving Fannie’s and Freddie’s debt securities was the Hobson’s choice Treasury made.
The Plan Won’t Stop the Problems
But don’t expect the really tough choice to be made-forcing Fannie and Freddie to dial back their $1.5 tn securitization portfolio, as there is little political will and resolve in Washington to do so.
Since the two are intrinsic to the $300 bn housing bailout bill, the Treasury says it will let them temporarily expand their mortgage-backed securities holdings to $1.7 tn from about $1.5 tn. Fannie’s balance sheet portfolio here is about $758 bn and Freddie’s is $798 bn.
A plank in the Treasury’s bailout has it that the two companies must then cut the size of their high-risk mortgage-backed securities portfolios starting in 2010 by 10% a year, to $250 bn from $850 bn each (or to a total of $500 bn down from $1.7 tn).
But do the math. Depending on how seriously Fannie and Freddie take this new rule–and who enforces it–it could take five to ten years to reach that $250 bn level, or even longer.
Will a future Congress and the Treasury still have the political will to cut Fannie and Freddie down to a manageable size?
Even Rep. Barney Frank (D-Mass.), for years an enabler of the reckless management of Fannie and Freddie, was quoted on Monday about this condition, “Good luck on that,” and that it would “never happen.”
