Fed Pressures Treasury Not To Wipe Out Fannie Mae Preferreds

The Federal Reserve has been quietly pressuring the Treasury Department not to adopt a rescue plan for Fannie Mae and Freddie Mac that would wipe out the value of their preferred shares, according to a source familiar with the matter. The Fed fears that any move that hurt the preferred could worsen the crisis in regional banks that is already under way.

At issue is $36 billion of preferred stock issued by Fannie and Freddie. Under several versions of widely discussed rescue plans for the mortgage giants, the US government would take a new preferred stake in the companies, subordinating or perhaps wholly eliminating the existing preferred. Critics of Fannie and Freddie believe such a move would be necessary to punish excessive risk taking by the companies and avoid creating additional 'moral hazard.'

The situation is complicated, however, by the large share of preferred stock held by regional banks, many of which are viewed as possible candidates for failure in these credit crunched times. As the Financial Times reported over the weekened regional banks and US insurers hold the majority of Fannie and Freddie'soutstanding preferred stock. The Fed has begun advocating against wiping out these shares, saying the threat to stability of the banks is greater than the 'moral hazard' argument, a source familiar with the matter says.

"The fear is that this bailout, if done in a punitive manner, could be costly, resulting in even more bailouts," the source said.

Last week Moody's cut Fannie and Freddie's preferred stock ratings from A to Baa3 on based on the uncertainty of how they would be treated in a rescue plan from the Treasury. That move could add to the need for the Treasury to take action soon, before banks are forced to report write-downs on the value of these lower-rated preferred shares. At the same time, the new pressure from the Fed to avoid wiping out the shares may stall an agreement on what form the intervention should take.