Mortgage Giants' Rescue Imperils Some Banks

Stock traders await the market's opening bell yesterday. Shares surged after the Treasury's weekend announcement.
Stock traders await the market's opening bell yesterday. Shares surged after the Treasury's weekend announcement. (By Henny Ray Abrams -- Associated Press)
Washington Post Staff Writer
Tuesday, September 9, 2008; Page A01

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.

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