Why Do Banks Own So Much Fannie and Freddie Preferred?

Posted by John Carney, Aug 27, 2008, 12:05pm

Sovereign Bank, which is based in Philadelphia, recently sent out a letter to customers disclosing that the bank owns large amounts of preferred stock issued by Fannie Mae and Freddie Mac. At least one customer in New Jersey reacted to the letter by running to the bank and withdrawing her deposits. We know this because we overheard her tell her friends this story in a barber shop this morning.

Even without sparking bank runs, the shares of many regional banks are suffering because of the risk that they will have to writedown their holdings of Fannie and Freddie preferred. Felix Salmon at Portfolio asks the obvious question: "what on earth were these regional banks doing holding the GSEs' preferred stock in the first place?"

It turns out that banking regulations and tax rules encouraged banks to buy Freddie and Fannie preferred stock. Regulators require to banks to maintain a capital cushion against losses on loans. This capital requirement can be met by holding cash or cash equivalents and certain investments that were considered relatively risk-free. The preferred stock of Fannie and Freddie was one of the highest yielding investments banks were allowed to hold to meet capital requirements, according to a person familiar with the matter.

Tax rules also made holding the preferred stock of Fannie and Freddie attractive. The tax code allows banks to exclude 70 percent of the dividends received on preferred stock from taxable income. The Fannie and Freddie preferred historically paid a high dividend, making this even more attractive.

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Comments

1

Posted by guest, Aug 27, 2008 12:15PM

f'n disaster

2

Posted by guest, Aug 27, 2008 12:17PM

"At least one customer in New Jersey reacted to the letter by running to the bank and withdrawing her deposits" = Bess Levin. And she needed the $13.43 for lunch anyway.

3

Posted by guest, Aug 27, 2008 12:19PM

She who panics first gets their money back...or at least more of it than the last to panic.

4

Posted by AJ, Aug 27, 2008 12:20PM

The highlight of the Portfolio article is that it reads "according to John Carney..."

Carney are you trying to replace Gasparino?

5

Posted by guest, Aug 27, 2008 12:25PM

It is surprising the Salmon wasn't aware of this fact already. The preferred is money good.

6

Posted by guest, Aug 27, 2008 12:45PM

If they invested in mayo they wouldnt have this problem

7

Posted by guest, Aug 27, 2008 12:57PM

"Tax rules also made holding the preferred stock of Fannie and Freddie attractive. The tax code allows banks to exclude 70 percent of the dividends received on preferred stock from taxable income. The Fannie and Freddie preferred historically paid a high dividend, making this even more attractive."

Any U.S. common stock and most preferred stock would allow for such a deduction; there is nothing special about Fannie and Freddie from a tax perspective. The fact that they pay high dividends shouldn't be any more important of a factor than it would be for calculating the return on any investment. If the point is that the dividends allowed for an attractive yield, then so be it, but it's not as though there is any sort of "special" tax break here.

8

Posted by guest, Aug 27, 2008 12:59PM

I'm a Sovereign customer, didn't receive a letter. I also own a a few thousand shares of Sovereign stock. It's all enough to make me cry.

9

Posted by guest, Aug 27, 2008 1:16PM

@7 True, but I think the point is that most other high yielding US common and preferred doesn't qualify as a 'cash equivalent' for the purpose of maintaining reserve requirements, thus the combination of high yield + eligibility attracted investment in the preferred.

10

Posted by guest, Aug 27, 2008 1:37PM

#9 has it right, that is what Carney and Salmon both were getting at. Also, can you source an article that used you as a source, or are Carney and Salmon just trying to build each other's ego

11

Posted by guest, Aug 27, 2008 2:10PM

I believe Fannie Preferred S Dividend Income qualifies for tax treatment for individuals @ 15%. ( Qualified Dividend Income ). Meaning 85% of the Dividend is tax Free. EJB.

12

Posted by guest, Aug 27, 2008 2:49PM

wtf were we doing in a barber shop in new jersey this morning???

13

Posted by guest, Aug 27, 2008 2:51PM

@11 - true, but WTF does that have to do with why so many BANKS are holding the stock??

14

Posted by guest, Aug 27, 2008 4:50PM

Carney, find out which central banks are holding a lot of FNM and FRE paper. Screw regional banks, I want to know which countries are going under in this clusterfuck.

15

Posted by guest, Aug 27, 2008 9:47PM

"This capital requirement can be met by holding cash or cash equivalents and certain investments that were considered relatively risk-free."

This sentence doesn't make a lot of sense to me. The capital requirements and capital ratios are very different from reserve requirements.

Can anybody give me chapter and verse on the meaning of the quoted sentence?

@9, particularly, claims that FNM prefs can be held as reserves - but I can't confirm that and it doesn't make a lot of sense to me since the Fed's been trying for ten years to get permission to pay interest on reserves.

jiHymas@himivest.com

16

Posted by guest, Aug 28, 2008 12:27AM

Carney, your explanation doesn't jive with the empirical data. The biggest owners of GSE pfds relative to the size of their balance sheet are smaller banks -- state-chartered and thrifts. State-chartered banks and thrifts have a 100% risk weighting on GSE preferreds, while national banks have only a 20% risk weighting. So why are the biggest owners the ones who had to set aside 5 times the capital? This was an investment *choice*, and GSE preferred owners should have to live with it or sell the pfds if they can't take the heat.

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