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Mortgage Giants' Rescue Imperils Some Banks

By Binyamin Appelbaum
Washington Post Staff Writer
Tuesday, September 9, 2008

The bailout of Fannie Mae and Freddie Mac threatens the financial health of several dozen of the banks that bought shares in the two companies, regulators say, including some institutions active in the Washington region and banks focused on less-profitable community development lending.

Executives at some of those banks say they felt encouraged to invest in the companies because a federal agency, the Office of the Comptroller of the Currency, had classified shares in Fannie Mae and Freddie Mac as extremely low-risk investments.

Stock in the two companies has now lost most of its value. Banks that held the shares as part of their reserves, the cushion of money that regulators require banks to keep on hand, must now raise money to replace the lost funds. With banks already hard-pressed to find investors, analysts said some banks that bet on Fannie Mae and Freddie Mac were now likely to fail.

The dramatic intervention Sunday by the U.S. government shook the world's economic landscape, profitably for some and painfully for others. Global markets surged as investors rejoiced in the promise of new capital, and mortgage prices started to fall, benefiting borrowers. The banking system may benefit if the mortgage market revives. But some banks already stressed by economic turbulence may not survive the tremors.

A number of the hard-hit banks are minority institutions or banks with a strong focus on community development, according to Rep. Maxine Waters (D-Calif.), who wants the government to help those banks raise replacement capital. At her request, Treasury Department officials agreed to meet with some bank executives today.

Some Washington area banks are also affected, including Gateway Financial Holdings of Virginia Beach, which bought $40 million in shares that were worth only $5 million at the end of trading yesterday, and Central Virginia Bank of Richmond, which said it would be "on the bubble" of needing to raise more capital if its holdings lose all of their value.

Fannie Mae and Freddie Mac were created by the federal government to increase the supply and reduce the cost of mortgage loans. The companies borrowed money at a low cost because the government involvement gave investors a sense of security. Fannie Mae and Freddie Mac used that money to buy loans from banks and other lenders, allowing those companies to make more loans.

Instead of relying on government funding, the companies sold stock to investors. The vast majority of those shares were common stock, the basic building blocks of a public corporation. But as Fannie Mae and Freddie Mac needed more money, they resorted to selling "preferred shares," which offered investors a higher dividend and greater bankruptcy protection.

Under the takeover, the value of both kinds of shares was sharply reduced. Shareholders now own only 20 percent of each company. If the companies continue to lose money, that stake could keep shrinking to the point of being completely worthless. And there will be no more dividend payments.

On Sunday, various regulatory agencies issued a joint statement saying they were aware of the banks' problems and would work try to help them raise additional capital if necessary.

Members of the banking industry say they interpreted the statement as an indication that regulators would show special mercy. One executive compared the situation to Hurricane Katrina, when banks were afforded leniency.

If regulators are inclined to do so again, there are tools at their disposal. They could give banks more time to raise money. They could also waive standard restrictions on banks that need to raise money, allowing them to use more aggressive strategies, such as gathering deposits through third-party brokers.

But it is not clear that the regulators intend to be lenient. An OCC official said the agency was inclined to help banks that were otherwise healthy. But other regulators said they could not describe any special plans to help banks. Treasury officials say they will simply help connect the banks with the right people at regulatory agencies.

Larger banks can more easily absorb the losses. J.P. Morgan Chase owns shares with a face value of $1.2 billion. A complete loss would erase a month or two of its profits but do no lasting damage. M&T Bank, a Buffalo company with branches in Maryland and the District, owns about $120 million of shares in the two companies.

"If you assume for a minute that we write off 100 percent of that investment, even if you did that, it would just have minimal impact on our capital. We have enough to be able to offset the negative impact," M&T Chief Financial Officer Rene Jones said during a presentation to industry analysts in New York yesterday.

For smaller banks, however, even smaller holdings can cause large problems.

Central Virginia Bank, a small lender based in Richmond, invested about $20 million in shares of the two mortgage finance firms. Charles Catlett III, the company's chief financial officer, said the bank did a preliminary analysis of the damage about a week ago. At that time, the bank still had enough money in its cushion. But since then, the value of the preferred shares has continued to fall.

If the shares completely lose their value, Catlett said, the bank would drop to the verge of needing to raise more money.

Catlett said the bank was "a sound financial institution." But he added that it was not easy for banks to raise money right now. Investors have largely lost their appetite for bank stocks, for example.

"It's a messy situation," he said, "but we are going to weather this storm."

As it became clear that the Treasury might craft a bailout that punished shareholders in Fannie Mae and Freddie Mac, banking regulators scrambled to determine how many could be hurt.

By last week, they had reached a preliminary conclusion that the damage would be limited to a relatively small number of banks, and even if all of those failed, the broader damage could be endured.

"Across the industry, banks do not have significant exposure," Sheila Bair, chairwoman of the Federal Deposit Insurance Corp., said Sunday. "Any negative impact will be narrowly focused only on a few smaller institutions."

But even now, regulators say they are still not sure exactly which banks are at risk, or how many.

The Office of Thrift Supervision estimated that about 2 percent of the roughly 830 institutions it supervises, or about 16 thrifts, held 10 percent or more of their capital in shares of Fannie Mae and Freddie Mac.

The OCC estimated that less than 0.5 percent of the roughly 1,640 institutions under its supervision have large concentrations of shares in the two companies.

The other agencies that regulate financial institutions have not offered public estimates.

Banks bought shares of Fannie Mae and Freddie Mac because their regular dividends offered a steady income stream. There were also tax advantages. But most important for many banks, under a system used to assess the risk of a bank's investments, the OCC assigned Fannie Mae and Freddie Mac shares the least risky grade possible.

"We certainly took that into consideration," said Ben Berry, chief executive of Gateway Financial, which has 40 branches stretching as far north as Charlottesville. The company is regulated by the Federal Reserve, but Berry said he still felt reassured by the OCC's judgment.

The bank spent $40 million on Fannie Mae and Freddie Mac shares late last year and early this year, according to its financial statements. At the close of trading yesterday, the shares were worth about $5 million; the value could continue to decline under the terms of the government's investment in the two companies.

Berry said he learned of the government's plan Sunday morning, while watching TV at home.

His reaction?

"Anger."

He said that the government-chartered companies had relied on banks to raise money and that the government should have protected those investments. He also noted that the ability of any bank to raise money by offering preferred shares was now compromised by the precedent that the government had established.

An OCC official said that the agency's risk assessments were broad guidelines and that banks were responsible for making their own risk assessments. He said it was "bad banking" for any institution to concentrate its investments.

The loss could force the bank to raise more money to meet regulatory requirements, but Berry said he was confident the bank would remain adequately capitalized.

He also noted that the shares could recover value if the government succeeded in stabilizing the two companies. In that case, shareholders could end up owning a smaller piece of a larger pie.

Staff writer David Cho contributed to this report.

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