naked capitalism

Readers may recall that the Treasury’s rescue plan for the GSEs called for preferred stock dividend to be eliminated and for new investment by the government to come in the form of preferred stock that would be senior to the outstanding preferred. Needless to say, those actions have had a rather deleterious effect on the price of said outstanding preferred.

One of the reasons that observers had assumed that the powers that be would not take actions that would be adverse to preferred was that US banks had been encouraged to buy it, so declines in price would be a hit to the equity of any banks who had the misfortune to trust the government as an investment advisor.

But a secondary reason was that any aggressive moves could also play havoc with the broader market for preferred stock. As the Financial Times’ John Dizard had noted:

The banking system needs to raise several hundred billion dollars of equity, and preferred stock is the lowest-cost way to do that in the public markets. While some sophisticated investors could distinguish between preferreds issued by a sound bank holding company, and preferreds issued by the overleveraged F&F, international investors and domestic retail investors would not have the data or analytics to draw the distinction.

The alternative, as I see it, to recapping the US banking system with preferreds is some form of direct government investing in the equity of banks or bank holding companies. That would be even more expensive to the taxpayers – as in at least 10 times more expensive.

Dizard is colorful and his 10x estimate appears to have been snatched from thin air, but the general point holds: preferred stock is a very useful tool for bank recapitalization, and the less tricks the banks can use, the more will come from the public purse.

And the scenario Dizard anticipated, which was either ignored or discounted, has come to pass. As before, welcome to the world of unintended consequences of government rescue operations.

From Bloomberg:

Prices of fixed-rate preferred stock fell an average of 11 cents to 69.8 cents on the dollar this week, including the biggest one-day drop in a decade on Sept. 8, according to Merrill Lynch & Co. index data. The 13 percent decline compares with a 0.8 percent drop in the Standard & Poor’s 500 index in the same time…

Paulson’s “actions have damaged the preferred market,” said Thomas Hayden, the investment strategist for Liberty Bankers Life Insurance in Dallas. “Somebody is going to be looking at an issue of Fannie or Freddie preferred shares that were rated AA up until a few months ago. If that’s not money good then what about the small regional bank in some part of the country?”

Hayden, whose $1.5 billion fixed-income portfolio contains preferred shares of Fannie and Freddie, said he’s “not interested” in buying any more preferred securities.

The market’s tumble is making it more expensive for banks and brokers trying to raise fresh capital after taking $506 billion of writedowns and losses on the collapse of the subprime-mortgage market….

The takeover was “unambiguously bad” for preferred investors and “likely set a precedent for any future rescue transactions,” Kathleen Shanley, an analyst at bond research firm Gimme Credit LLC in Chicago, wrote in a Sept. 7 report…

Freddie preferred shares have lost 83 percent the past two days, while Fannie’s have declined 80 percent, the biggest losers in the Merrill index. The two companies account for about $24 billion of the $190 billion par amount in the index. Forty of the top 50 issuers have declined in the last two days…

Citigroup Inc., the fourth-biggest U.S. bank by market value, lost $450 million this quarter on investments in Fannie and Freddie, including writedowns on preferred securities, the New-York based bank said in a filing today. E*Trade Financial Corp. will have a pretax loss of $150 million this quarter from selling its shares, the New York-based company said in a filing…

“In the primary market it’s going to be much more difficult for financials across the board,” Hayden said. “If Lehman Brothers thought they needed to go to the market and had any chance at all of issuing preferred stock to raise capital, it is now three times more difficult than it was last Friday.”