Treasury Secretary Henry M. Paulson Jr.'s decision last week to seize Fannie Mae and Freddie Mac may choke off the biggest source of funding for financial companies that are suffering from the collapse of the subprime mortgage market.
Concern about the ability of brokerages and banks to raise money escalated yesterday after Lehman Bros. Holdings Inc. filed for bankruptcy protection and Merrill Lynch & Co. agreed to be bought by Bank of America Corp. For example, American International Group Inc., the insurer struggling to avoid credit downgrades, is seeking billions of dollars in fresh capital to shore up its balance sheet.
Financial firms and other companies often used preferred stock to raise money. If there is a default, preferred stock ranks in priority behind bonds and ahead of common shares in a company's capital structure. Unlike common stock, the securities pay either a fixed- or floating-rate dividend, and can have a set maturity or no due date.
When Paulson took control of Fannie and Freddie, he scrapped dividends on the preferred stock of the government-sponsored enterprises. He also said the United States would buy as much as $200 billion of new Fannie and Freddie securities that would rank ahead of existing issues.
That scared investors into abandoning preferred shares, pushing prices of the fixed-rate portion of the stock market down an average of 13 cents last week to an average 67.1 cents on the dollar, the lowest in at least a decade, according to Merrill Lynch index data.
When the price declines, the yield rises: The average yield on preferred stock rose last week to 10.8 percent from 8.8 percent on Sept. 5 and 7.9 percent at the end of last year.
Paulson's plan for Fannie and Freddie sent preferred shares overall tumbling on concern it will become a model for financial institutions that already are reeling from $511 billion of writedowns and credit losses since the start of 2007.
During that period, financial companies raised $361 billion in capital to replenish their balance sheets, data compiled by Bloomberg show. Banks with the 10 biggest writedowns sold at least $85 billion of preferred securities, or 47 percent of the total, the data show.
Paulson's "decision has been devastating to the market," said Marilyn Cohen, president of Envision Capital Management in Los Angeles. "We all thought they would never help exacerbate the banking crisis - and that's exactly what they did."
