From Sovereign (SOV) to JP Morgan (JPM) banks make headlines with writedowns on their holdings of Fannie’s (FNM) and Freddie’s (FRE) preferred stock, but the obvious question of how stock ever got onto banks’ balance sheets is only asked by Felix Salmon – and even he doesn’t know the answer. In general, banks are barred from investing in equity securities. However, the government made Fannie and Freddie preferred stock a “permissible” investment to create a sufficiently large market for these securities.
Of course, making the stock “permissible” didn’t necessarily make it attractive, so regulators had to pull another trick. Under the risk-based capital rules, national banks may carry agency preferreds at a 20 percent risk weighting, while state-chartered banks and OTS-regulated savings associations must apply a 100 percent risk weighting. This means that banks only have to hold 1.6% or 8% capital against their investments (or should we say ‘speculation’?) in Fannie and Freddie preferred stock. This compares to 8% that must be held against senior commercial loans, which have a much more favorable risk profile than any equity, and dollar for dollar capital requirements for other preferred or common stock.
Another appealing feature of the preferreds is their eligibility for the 70% dividends-received deduction under IRS rules. So only 30% of a dividend payment is taxable for the bank. Assuming a 35% tax rate, Uncle Sam will get only about 10% in taxes on preferred Fannie and Freddie dividends. So preferreds pay bond-like interest at better after-tax returns. The resulting taxable-equivalent yield is a nice spread above most banks’ funding cost. No wonder then that banks loaded up on most of the $36 billion of outstanding Fannie and Freddie preferreds. After all, you have to dance while the music is playing.
So why exactly did banking regulators award this favorable treatment for GSE preferred equity? Because otherwise there would have been no market to place $36 billion of preferred stock. 14 out of 21 of Freddie Mac’s preferred issues were sold after 2000. For Fannie, 15 of the 16 preferred issues were issued after 2000, the bulk of them after 2005. This happened to be the the time when OFEHO had imposed a capital penalty on the GSEs and forced them to raise additional capital – in preferred stock.
Most preferred stock is bought by corporations seeking tax-advantaged alternatives to bonds. Despite potential interest from corporate treasuries, placing $36 billion of two firms quickly in such a narrow and specialized market is impossible. Therefore, the government had to create a market for the preferred stock of the two GSEs, and what easier way to place it than to encourage the institutions that have the money to buy the stuff. Some of the preferred stock was clearly structured to appeal to banks rather than income-oriented investors. Not many buyers chasing yield will get excited by Fannie’s Series F preferred that pays a whopping 2-year CMT rate minus 0.18%. Such a preferred stock only makes sense in the portfolio of an investor that gets a low weighting for regulatory capital purposes, gets a tax break and has a low cost of funds at a variable rate. That type of investor looks just like a bank to us.
Effectively, what is considered equity at the level of the GSE’s is in fact highly leveraged debt when you look at the financial system as a whole. This is hardly a recipe for safety and soundness.
Now that Fannie and Freddie are in trouble, the government is in a bind. After encouraging banks to buy FNM/FRE preferred by loosening regulations, they can not easily make the banking sector take $36 billion of writedowns on securities that banks only invested in because of strong government incentives. Bailing out preferred investors is less a question of moral hazard than of credibility of bank regulators. Predictability and stability of government regulations make for stability. Encouraging banks to invest in the two GSE’s preferreds and then making them take a writeoff won’t help restore confidence in regulators.
We are curious to see how the government will get out of that quagmire. Too steep a haircut on the preferred is out of the question for the risk of further credit contration. $36 billion of writedowns decreases banks’ lending capacity by at least $450 billion. The market tells us that bank’s won’t take any risk with unpredictable government action. Some adjustable rate preferreds (FNM-PF) are trading at an 80% discount to their liquidation value, whereas fixed rate preferreds (FNM-PT) are only at a 50% haircut. Investors who can tolerate some spread volatility can lock in the spread and profit from liquidity-seeking banks’ indiscriminate selling.
Disclosures: Thomas Kirchner is long FNM. He manages the Pennsylvania Avenue Event-Driven Fund (PAEDX), which is long and short various FNM and FRE securities. He is a former FNM employee.
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