October 3, 2008
Gerald Baldwin

 

It has been less than 30 days since the federal government took over Fannie Mae and Freddie Mac. Operating under recently enacted law, the Federal Housing Finance Agency put both of the mortgage giants into conservatorship. That means the federal government saved these huge players in the mortgage market – at least temporarily. In the month since the take-over, Wall Street has seen other big players fall. Lehman filed bankruptcy; Washington Mutual tumbled; Wachovia is no longer. Let’s not forget the ongoing Congressional debate (some might say fighting) on how to fix the credit problems we face.

However, one problem seems to have gotten little attention in the past month, over-shadowed by the “big” problems: the bailout of Fannie and Freddie may have caused the end of any number of well-run community banks and materially impacted many others. Overnight, they faced serious capitalization losses and regulatory non-compliance. We all know that banks are required to meet certain capitalization requirements. One of the few types of securities that could be counted within their capital base were the preferred shares of Fannie and Freddie. In recent times, there was even a governmental push for bankers to acquire such preferred shares. And, then the bottom fell out. Many banks have consequently suffered serious hits. Some, perhaps catastrophic hits. The American Banking Association released a recent survey revealing that 27% of the banks face combined losses of $10 to $15 billion. Others predict that this event alone will cause a dozen bank failures and force the sale of 40-50 others.

By and large, these banks were not guilty of any practices remotely related to the sub-prime loans that spawned the Wall Street bloodbath, yet they will be victims. They are victims of their faith in the federal government in the form of Fannie and Freddie. Nor did it help that government “spokespersons” insisted Fannie and Freddie were healthy.

Regulations require that banks maintain a certain level of their capital in safe, liquid investments. Many community banks invested their capital in preferred shares of Fannie or Freddie – the next best thing to government paper, or so they thought. When FHFA took control of Fannie and Freddie, the price each company paid for the bailout was the issuance of $1 billion in preferred shares to the federal government, diluting the value of the previously issued preferred shares. Since community banks owned many of those shares, the resulting devaluation of the preferred stock wiped out the capital of many of these smaller, non-Wall Street banks.

The result has been, and will continue to be, painful to community banks who held no risky mortgages, who didn’t purchase any mortgage-backed securities, who did not participate in credit default swaps. Through no fault of their own, their diluted capital will dictate that they either will go out of business or be acquired by a bank that had not invested in the “safe” preferred shares of Fannie or Freddie.

The attorneys at Frost Brown Todd, LLC are familiar with the bank’s capitalization requirements and with dealing with state regulators should this issue ever come up with your bank. Our Tax Group is daily monitoring developments. Presently, such capital loss events only qualify as a deduction against earned capital gains, not a meaningful result for most community banks. If you are interested in staying abreast of developments in this area, whether it be regulatory, taxation or corporate control issues, let us know and we will directly provide you with our updates.