Capital Levels Are a Question Mark with GSE Issue Hanging

Without a tax benefit for losses on its Fannie Mae and Freddie Mac preferred stock, the $980 million-asset Cooperative Bankshares Inc. in Wilmington, N.C., expects to slip below the well-capitalized level.

If that happens, Rick Willetts, Cooperative's chairman and chief executive officer, said he hopes regulators refrain from imposing the typical restrictions.

But exactly what to expect is a looming question for many companies. Though the regulatory agencies have promised leniency in public remarks, specific actions they might take in dealing with companies like Cooperative remain uncertain.

"What they'll do with us individually, we don't know yet," Mr. Willetts said. "But they've made general comments that if you become adequately capitalized solely as a result of the Fannie and Freddie issue, they are going to grant waivers as liberally as possible."

For instance, only well-capitalized banks are allowed to have brokered deposit programs, he said. So a waiver to continue taking brokered deposits would be helpful.

"Right now those are lower-cost sources of funding than the retail market in our area," Mr. Willetts said.

The Federal Deposit Insurance Corp. and the Office of Thrift Supervision did not reply to inquiries on this topic. The Office of the Comptroller of the Currency referred back to a written statement issued after the government takeover of Fannie and Freddie last month, indicating that few banks would be greatly affected and that the agency would work with those that are.

Mr. Willetts said that regulators are aware of Cooperative's plan for returning to well-capitalized status after taking its expected $9 million loss and that they have thanked him for being proactive.

"We're just not far enough along in the process to be able to tell you definitively what they will or won't do," Mr. Willetts said. "And I don't know that they're prepared yet. They say they're going to take it on a case-by-case basis."

A provision in the original rescue proposal would have allowed those that hold shares in the two government-sponsored enterprises to get a tax benefit from selling them at a loss.

Several bankers said they are rooting for this provision to be included in any reworked bill. Though the change being proposed would not negate their Fannie and Freddie losses, it would help.

"That's a big deal to us," said Ralph Larry Lyons, the president and CEO of the $507 million-asset Central Virginia Bancshares Inc. in Powhatan.

Mr. Lyons said his company expects to be adequately capitalized if it has to take an estimated $16.6 million loss on its Fannie and Freddie stock. "But if this had been tax-deductible, we would've been well capitalized at the end of the day."

The way the law is now, the sale of these equity securities would have to be treated as a capital loss.

"The reason that's a problem is, it's very hard for banks to come up with a capital gain to offset this loss," said Cheryl VanderBaan, a tax executive at Crowe Horwath LLP.

But the proposed change would allow banks to take an ordinary loss instead.

At a typical tax rate of about 35%, banks would end up shaving off roughly a third of that loss. The banks also could offset the loss against ordinary income.

Sung Won Sohn, an economist at California State University, said some banks' capital is likely to erode anyway.

"That would be useful only if you do have income, and right now the earnings picture is not that good," Mr. Sohn said.

"When you have a loss, first it will hit income, and if you don't have sufficient income, it eats into capital. To me, the concern is: Will my capital be eroding, forcing me to go out and get additional capital in these difficult markets?"

Brian Gardner, an analyst at KBW Inc., said the provision to allow an ordinary loss is expected to remain in any reworked version of the rescue bill.

"Republicans pushed for this, and taking it out would probably lose some Republican votes," he said. "So I think right now, if there is a bill, the GSE component is likely to remain in it."

Chuck Laetsch, the partner in charge of the Florida tax practice for Crowe Horwath, said regulators must follow the tax code, so only Congress or the Treasury Department could make the change banks are seeking.

"Treasury has the ability to offer interpretive regulations. Whether or not this is the kind of issue that would fall under the interpretive window, I don't know," he said. "The code is clear on this issue, that any realized loss on the sale of these preferred stocks would be capital and not ordinary in nature."

Robert Davis, the American Bankers Association's executive vice president for mortgage, finance, risk management, and public policy, said the ABA is talking with Treasury officials about the possibility of the department's authorizing a change to an ordinary loss should the rescue bill fail.

At stake is more than just bank earnings, Mr. Davis said.

Lending would shrink by up to $100 billion nationwide if banks' capital is depleted by the full losses on their Fannie and Freddie stock, the ABA estimates.

"There's a significant macroeconomic effect, at the worst possible time for the economy," Mr. Davis said.

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