Fannie-Freddie rescue affects 'preferred' shareholders

and Jeffrey H. Birnbaum

WASHINGTON — A top concern of Treasury Secretary Henry Paulson as he ponders whether to pull the trigger on a rescue plan for mortgage financiers Fannie Mae and Freddie Mac is the fate of its "preferred" shareholders, which include regional and community banks across the nation and central banks around the world, according to private analysts who closely follow the department.

Despite mounting financial woes, Fannie Mae and Freddie Mac have been paying an unusually generous dividend to owners of preferred stock — which is issued to a select class of investors — making the shares popular among banks. Treasury officials are worried that a sell-off of these shares poses serious risks to the broader financial system, the analysts said.

The value of the preferred shares, estimated to be worth $36 billion between the two firms, has taken a hit recently. Moody's Investors Service significantly downgraded some of them last week, saying their dividends could be at risk as the firms falter.

The performance of the preferred shares is one market development Treasury is closely watching as it decides whether to inject government money into the two companies, which back about half of the $12 trillion in mortgages in the United States. The department is also monitoring the confidence of banks, financial firms and investors that lend to Fannie Mae and Freddie Mac on a daily basis.

Lenders have continued to buy their debt but only at higher rates. Any sign of panic or outright refusal to lend by these debt holders would spur Treasury to act, analysts who closely follow the Treasury said.

A big test is approaching. By early next month, the two companies will seek to refinance about $225 billion in mostly short-term loans that are coming due, according to a research note from Barclays Capital. Fannie Mae has about $120 billion of debt maturing through Sept. 30, while Freddie Mac has $103 billion.

"One trigger would be if they are unable to roll over their debt in a profitable manner," said Paul Miller, industry analyst for Friedman, Billings, Ramsey Group.

The perils facing Fannie Mae and Freddie Mac are different from those that brought down investment bank Bear Stearns in March, forcing the Federal Reserve and Treasury to help arrange an emergency sale to J.P. Morgan Chase. In the case of Bear Stearns, federal officials responded to a bank run that was threatening to render the firm bankrupt within hours.

As mortgage finance companies, Fannie Mae and Freddie Mac are not vulnerable to such a run. Instead, analysts said Paulson is intent on stepping in when he detects that confidence in either firm has been lost. They add that Paulson would ultimately have to make a judgment call.

With regard to equity, the dominant concern is about preferred stock rather than more widely held common stock. Preferred shareholders get paid in a bankruptcy before common stockholders and can receive large dividends. Because of the high dividend payment and the government's implicit backing of Fannie and Freddie, many banks considered them a very reliable source of capital.

Some investors have expressed concerns that under a Treasury bailout officials could take action rendering the companies' stock worthless or eliminating the dividends. This could leave banks undercapitalized. That is why Treasury is considering how to keep Fannie Mae and Freddie Mac as stock-based companies rather than having the government take them over outright, analysts said.

"There's a lot of internal lobbying of Paulson to try to maintain some value in those preferred shares," Miller said. "There would probably be some banks that fail if the preferred gets wiped out."

Other analysts who closely follow the Treasury said that no action appears imminent this weekend. Paulson has repeatedly said he has no plans to use the new authority that Congress granted him July 30 to lend or invest in the two companies.

Treasury has said very little in recent days, in an effort to contain market alarm over the two companies, analysts said.

"We continue to communicate with the companies and their regulators and are staying on top of the situation," said Treasury spokeswoman Michele Davis, declining to elaborate.

The powers granted to Paulson were broad enough to give him several options. He could buy bonds from the firms, essentially giving them a loan, or create a special class of preferred shares that would require the firms to refund the government's money before that of other shareholders in the case of a bankruptcy, analysts said.

Some of the banks with the biggest exposure include Regions Financial, which has an estimated $200 million, M&T Bank with $161 million, and Astoria Financial Corp. with $83 million, according to Fox-Pitt Kelton, an investment bank.

"If the preferred is wiped out, that hurts the entire banking system," said Howard Shapiro, an industry analyst for Fox-Pitt. "There are numerous banks that have a fair amount of exposure. This is just another difficulty that the banks, who are short of capital, will have to overcome."

But Len Blum, managing director at Westwood Capital, said that may be unavoidable.

"It's absolutely ridiculous that Fannie and Freddie are still paying out dividends," he said. "And it's ridiculous that you would have a company where shareholders make all kinds of money when the housing market is good and taxpayers have to shoulder all the costs when the housing market is bad. How is that good for the nation? I think it's only fair to taxpayers that the preferred shareholders get wiped out."

Instead of trying to prop up the value of preferred shares, regulators should be encouraging community and regional banks to raise capital to replace those investments, he added. "We have to be realistic about what things are worth," Blum said.

Shares in Washington-based Fannie rose 15 cents, or 3.1 percent, but have lost more than 90 percent of their value over the past year, while those of McLean, Va.-based Freddie dropped 35 cents, or 11 percent, and are down nearly 96 percent over the past year.

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