WASHINGTON — If the government is forced to rescue Fannie Mae or Freddie Mac, what impact would that have on the thousands of banks that hold preferred stock and subordinated debt in the government-sponsored enterprises?
Though some of the answers are alarmist, asserting the likelihood of a wave of failures, the situation does not appear as serious as many estimate. We sort through the issues below:
Just what is the industry's exposure to Fannie and Freddie?
Federal regulators will not say, but in the aggregate, it does not appear to be much.
Preferred stock at the GSEs totaled $36 billion at June 30, and subordinated debt was $15 billion. It is impossible to know — at least from public data — how much of either is held by financial institutions. But even if banks held all of it, $51 billion is not a lot in a $13.3 trillion banking industry.
One of the few estimates hazarded came last week from Samuel Caldwell, a research analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc., who estimated that $10 billion worth of GSE preferred stock may be held by banks and thrifts.
But I thought banks owned a lot of GSE debt and securities?
They own a ton of senior debt. Trying to figure out how much would be an exercise in futility, but based on March 31 call report data, banks and thrifts own less — probably much less — than $210 billion of GSE senior debt.
Few observers are concerned about this, however, because the government is almost certain to back any senior debt of the GSEs. The consequences of not doing so — to U.S. banks and foreign central banks — would be disastrous for the global economy.
Whether the government would back preferred stock or subordinated debt, however, is less clear.
What are the regulators saying?
Not a lot, and that is fueling anxiety. The Office of Thrift Supervision has been the only regulator to offer any detail. It said last week that just 2% of the institutions it supervises have as much as 10% of their Tier 1 capital in Fannie and Freddie securities.
Federal Deposit Insurance Corp. Chairman Sheila Bair said her agency is "closely monitoring the situation" and that "the amount of preferred GSE securities out there is not problematic, though for smaller institutions the extent of the holdings may be an issue." The agency is primarily focused on smaller banks, she said.
A spokesman for the Office of the Comptroller of the Currency said, "We have a very small number of community members — fewer than 1% of the banks we supervise — with meaningful exposures to GSE preferred stock."
As for larger banks, he said: "We don't believe our large banks have significant exposures as a percentage of capital."
A spokeswoman for the Federal Reserve Board would say only that the central bank is "in regular contact with the institutions we supervise."
None of the regulators estimated holdings of subordinated debt, but this is considered less an issue than preferred stock.
So what do we know?
Every detail to date has come from the affected institutions themselves or from analysts. JPMorgan Chase & Co. said last week that it has $1.2 billion of GSE preferred stock, which could prompt a $600 million third-quarter writedown.
KBW also released one of the most comprehensive assessments of the industry's exposure. Among large banking companies, only M&T Bank Corp. and Fifth Third Bancorp have holdings worth noting. M&T holds $120 million, or 4% of its tangible capital, in GSE preferred stock; Fifth Third has $55 million, or 1% of its tangible capital.
It is a different story among the next-smaller tier, where 37 banks are known to have exposure to preferred stock from Fannie and Freddie, totaling $1.3 billion. The company whose GSE preferred is the biggest share of its capital, according to KBW, is Gateway Financial Holdings Inc., with $38.5 million, or 34% of its tangible capital.
The runner-up is Midwest Banc Holdings Inc., with $62 million, or 32% of its tangible capital, tied to Fannie and Freddie preferred, then Westamerica Bancorp., which has $44.5 million, or 16% of its tangible capital.
It is not clear that any institution has disclosed a significant holding of GSE subordinated debt.
Some banks are going to great lengths to assure the public they are not exposed to the GSEs. Amcore Financial Inc. said Friday that it does not "own common stock, preferred stock, or sub debt" in either enterprise.
What happens if preferred stock or subordinated debt were to be wiped out?
It would remove a source of capital from banks' balance sheets.
Banks are already having trouble on the capital front and can ill afford to see their cushion shrink. So the big worry is that wiping out preferred shareholders could tip some banks into failure.
"Any bank who is going to report a big loss on this stuff will see lower capital and will have difficulty raising money," said KBW's Mr. Caldwell. It could put some on "a slippery slope."
It could cause a bank to fail?
It is unlikely to do so by itself, but it could worsen liquidity problems at banks that are already troubled. Unless these institutions are able to find capital quickly, their days could be numbered.
This, however, would probably be limited to relatively few institutions, observers said.
"It's an issue for a few banks, but it isn't a broad issue for the industry," said Bert Ely, an independent analyst in Alexandria, Va.
So what's the government going to do?
The growing conventional wisdom is that the government will have to intervene at some point, especially if the GSEs run into trouble selling their debt.
The end result would be that Fannie and Freddie would be nationalized, privatized, or some combination of the two. But it is unclear how the Treasury Department would treat shareholders and subordinated debt if it does act.
What are the possibilities?
Common shareholders, who are lowest on the totem pole in a receivership, would almost certainly be wiped out in a government intervention. This is why the stock price has been so battered in recent weeks, including Friday, when shares of Fannie lost 14%, to close at $6.84, and Freddie's stock closed off 14.5%, at $4.51.
Any bank holding common stock would take a loss. For example, Glacier Bancorp. Inc. said Friday that it had a temporary unrealized loss of about $2.8 million as of Thursday on investments in Freddie's preferred stock and Fannie's common stock.
What about preferred shareholders?
Most observers expect at least some degree of impairment in the event of an intervention.
"Stock isn't stock if taxpayers take losses before shareholders," said Thomas Stanton, a fellow of the National Academy of Public Administration. "A bailout [of preferred shareholders] would upset the traditional order of risk-sharing."
What about subordinated debt?
The Treasury could eliminate preferred shareholders but bail out subordinated-debt holders, or erase them both. But observers are divided on how it might act. Some saw a guarantee like that for senior debt, but others expected a wipeout.
What happens then?
If preferred stockholders and subordinated debt holders are wiped out, regulators would probably face pressure to allow more capital into the banking system somehow. The Federal Reserve Board is already considering allowing private-equity firms to hold larger stakes in banks — a wipeout of preferred shareholders might hasten a decision.
"Right now, the markets are nervous, and the Fed … is looking for ways to get capital into the banking sector, and the issue of Fannie and Freddie stock merely adds to a solution of that kind," Mr. Stanton said.
Are there other options short of a full-scale wipeout?
The Treasury could let preferred shareholders remain whole but bar Fannie and Freddie from paying dividends. This, too, would raise problems for the industry. "The bigger risk is a dividend suspension," said Brian Harris, an analyst at Moody's Investors Service. "A dividend suspension is a loss, so from our standpoint, a dividend suspension is a substantial event. We would consider that to be the equivalent of a default."