We have said more than once that a terribly misguided aspect of the Freddie and Fannie conservarorship was the elimination of dividends on the GSE’s preferred stock. Preferred was the best vehicle that struggling financial firms had for raising new capital. Eliminating the dividend lead to big losses in all financial preferred stocks, since investors assumed any bailout would similarly trash the preferred. Indeed, it is quite possible that this move accelerated Lehman’s demise, since it closed off its best funding option.
A second reason for taking a dim view of this move was that the Treasury had encouraged banks to buy Fannie and Freddie preferred stocks, so any losses on these holdings would reduce the equity of banks that owned the stock. Paulson alluded to the issue in his statement announcing the conservatorship, and claimed very few banks would be affected, and the impact would not be significant:
The agencies believe that, while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.
It looks like they were wrong. From the Financial Times:
US regulators have underestimated potential bank losses on preferred stock issued by Fannie Mae and Freddie Mac, the American Bankers Association said on Monday.
Nearly a third of US banks hold preferred stock issued by the two mortgage financiers that were taken into conservatorship this month, according to an industry survey conducted by the ABA. The average bank exposure to such securities relative to core equity capital was 11 per cent.
“The negative impact on banks – particularly Main Street community banks – is far greater than regulators first thought,” wrote Edward Yingling, chief executive of the ABA in a letter to the Treasury, the Federal Reserve and other banking regulators.
The government takeover of Fannie and Freddie all but wiped out the value of $36bn of their preferred shares. This would force exposed banks to take writedowns at the end of the third quarter that could impede future lending, the ABA warned.
“When the actions were contemplated to reduce dividends on Fannie Mae and Freddie Mac preferred stock, the bank regulators estimated that only a dozen banks would be affected by it,” Mr Yingling said.
Regulators said this month only a small handful of banks had “significant” holdings in Fannie Mae and Freddie Mac relative to their capital bases and that they would help develop plans to restore capital at these banks.
However, the ABA survey suggests the impact of writedowns could be more widespread and more severe than regulators initially indicated, particularly among small community banks that engage in lending for small and medium-sized local businesses.
The ABA’s letter called for regulators to reconsider the suspension of dividend payments on Fannie and Freddie preferred stock to alleviate the capital impact on banks and avoid a multi-billion dollar decline in lending.