Why Do Banks Own So Much Fannie and Freddie Preferred?

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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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