On the advice of their auditors, many community banks have written down the value of their Fannie Mae and Freddie Mac preferred stock because the stocks have fallen below their purchase prices and there is no telling when they might come back.
The writedowns have forced at least a dozen publicly traded banks - and perhaps many more privately held ones - to take charges against their earnings over the past two quarters. Accountants say more banks could end up recording such charges in future quarters if the stocks' value continues to decline or other investments become impaired under new accounting rules.
The value of Fannie and Freddie's preferred stock has dropped in recent months in the wake of the mortgage giants' accounting woes. Though the stock has fluctuated in the past, banks were not as quick to write down the value, because the drop-off could be tied to the interest rate cycle, and banks could argue that the price would recover as rates moved.
But auditors and bankers worry that the cause of the most recent declines may be that the accounting and regulatory scrutiny Fannie and Freddie have faced in recent months could affect the government-sponsored enterprises' ability to make payments on preferred stock over the long term.
Also, auditors say new Financial Accounting Standards Board guidance on impairments has given companies less flexibility in deciding when and when not to write down the value of their investments. Banking trade groups are starting to take a closer look at this issue.
In earnings releases banks readily pointed out that these charges were not a result of problems with day-to-day operations. In fact, some that have taken large charges against their Fannie and Freddie holdings reported healthy profits for the same quarter.
Still, it is a trend worth watching. David M. Burns, the Northeast practice leader for financial institutions at Grant Thornton LLP in Philadelphia, said that no one knows how many banks are affected but that a large number, both privately held and publicly traded, own the preferred stock.
Representatives from Fannie and Freddie separately said they did not know how many banks own their stock and could not comment on accounting practices used by banks.
The Financial Accounting Standards Board's Emerging Issues Task Force issued guidance last year for deciding whether an investment is other than temporarily impaired. What that means is that the price of a security has fallen below the purchase price, and the bank cannot make a reasonable forecast of when the price might recover so that the bank would not be forced to sell it at a loss.
The guidance said that unless there is some kind of positive evidence that an investment's price is likely to recover, then the longer its market price is below its book value, the less likely it is to recover.
As Fannie and Freddie's accounting and regulatory problems have mounted, the preferred stocks' market prices have fallen below their issue prices.
Preferred stock is stock that pays a fixed dividend, and its holders have claim ahead of common stock holders on the assets of the corporation. As with bonds, the value of preferred stock fluctuates with interest rates and with news about the issuer that may affect investors' confidence in its ability to pay dividends and repurchase the stock.
Not all the issues have behaved the same way. For example, Fannie Mae noncumulative Preferred Stock Series G was issued in 2000 with a par value of $50 per share. On May 12 it closed at $35.61. Freddie Mac noncumulative Preferred Stock Series D, issued in 1997 with a par value of $50 a share, closed on May 13 at $50.20.
Differences in the dividend rates, the change in interest rates, and perceptions of Fannie Mae and Freddie Mac could be among the reasons that investors have treated these stocks differently. And the differences in how the various series of preferred stock have performed help explain why some banks were hit harder than others - and why many are not taking charges at all.
For example, FFW Corp. of Wabash, Ind., recorded a second-quarter loss of $1.2 million after posting net income of $634,000 for the year-earlier period (its second quarter ends Dec. 31). It blamed a $1.8 million charge it took on its Fannie and Freddie preferred stock.
But the $1.8 billion-asset West Coast Bancorp of Lake Oswego, Ore., reported earnings per share of 33 cents for the first quarter of 2005 - unchanged from the same period a year earlier - despite an $803,000 impairment charge on its Fannie and Freddie stock.
Sydney Garmong, a technical communications executive with Crowe Chizek & Co. LLC in Washington, said not all banks that hold Fannie and Freddie stock are taking charges. This is because the accounting rules say banks should evaluate securities on a case-by-case basis to see whether any are other than temporarily impaired.
"It depends on when you bought the stock and when it reprices," Ms. Garmong said.
Mr. Burns said new accounting rules dictate that banks look at all of their investments that are trading below the price at which they bought them. If the price has dropped because of long-term issues and shows no signs of recovery, the investments have what accountants call "other than temporary" impairment, so the banks have to take a charge on the securities whose prices have declined, and the recovery cannot be predicted.
"This applies to all debt and equity securities owned by a bank," Mr. Burns said. "This just happens to be with the challenges of Fannie and Freddie. The people who own these are saying, 'We have a problem here.' "
An example of a bank that has applied "other than temporary" rules to more than just Fannie and Freddie holdings is the $3.2 billion-asset Independent Bancorp of Ionia, Mich. It recorded a $100,000 charge on Fannie and Freddie stock, and a similar $200,000 other-than-temporary-impairment charge on a security backed by a mobile home.
Nonetheless, Independent made money. Its diluted earnings per share were 52 cents, 24% more than a year earlier.
Though it is unclear how many banks own these stocks, the issue has caught the industry's attention. The Oklahoma Bankers Association included a session on other-than-temporary impairment for all securities at its annual conference in April, and the national trade groups have been studying the matter as it applies to all securities.
Industry representatives do not agree with auditors that banks should take a hit for holding the Fannie and Freddie securities.
Donna Fisher, the American Bankers Association's director of tax and accounting, said she did not think that the preferred stock should be marked down, because it was like a debt security. As long as the credit quality remains good, the buyers of debt should get their money back at its maturity, she said.
The Fannie and Freddie preferred stock was perpetual, meaning it has no maturity date. That is why it is being treated like a stock by some accountants and thus written down, Ms. Fisher said.
"Perpetual preferred stock trades more like debt," she said. "We do not think you should mark down debt securities."
