The Fed-Fred Trade, Preferred Stock Edition

Author:
Updated:
Original:

Banks who bought short-term bonds sold yesterday by the government chartered mortgage giant Freddie Mac may have also boosted their own balance sheets by strengthening Freddie's preferred stock.


Yesterday we described how the banks could utilize the Federal Reserve's Term Auction Facility to essentially buy Freddie bonds on margin, achieving an outstanding return on risk capital. The movement in Freddie's preferred stock since the success of the bond sale suggests that the bond buy may have created value for banks by pushing up the value of Freddie's preferred shares, the majority of which are owned by regional banks.
Freddie's preferred shares, which have been on a steady decline for months, are up nearly 8% for the day. There had been widespread fear that a government rescue of Freddie would wipe out the preferred shareholders, possibly by subordinating them to new government-owned preferred shares. This began a good deal of wrangling at the Treasury Department when it became clear that such a wipeout would trigger major losses at regional banks holding the shares, possibly causing banks to fail. Just the possibility of such a wipeout was viewed as inviting runs on shaky banks with Freddie preferred on the books.
The news of Freddie's success at placing $2 billion in bonds was greeted as a show of confidence in the mortgage giant, without much attention paid to the way the Fed helped finance the bonds. This alleged bond market confidence, in turn, has been interpreted as indicating that a government rescue is less likely. This in turn, probably helped the preferred shares trade up.
In short--or should we say, in "long"--buying Freddie bonds would have been a very lucrative and inexpensive trade for banks holding Freddie preferred.

Related