What do you do with the current preferred shares? A significant portion is held by banks in their capital base. JPMorgan Chase just wrote down $600 million in Fannie and Freddie preferred shares this week. Many other banks will be doing so as well.

As I noted last week, there are banks that have more than 20% of their capital base in these shares. In today’s current environment, do we want to deal with the costs to the FDIC of even more failed banks? And even if you don’t force a bank into outright failure, you at best limit its ability to function as an efficient market lending agency to local businesses and consumers.
But you can’t just say, “We will cover the preferred shares in banks, but not in personal accounts or in the accounts of other institutions.” It's an all or nothing proposition. A $36 billion proposition.

It's a potential Hobson’s choice. Wipe out the preferreds or wipe out the shareholders of a lot of banks and have the FDIC pick up the costs. By the way, Congress and bank regulators encouraged banks to buy preferred shares by giving them special status and tax breaks.

But what about the $19 billion subordinated debt? That $19 billion is actually on the banks’ books as capital for Fannie and Freddie and not as debt, because there is a clause in the bond that says if the bank is in a situation where it must be bailed out, the interest payments on those bonds can be postponed for 5 years. That allows them to count the debt as capital. If the companies are declared insolvent by their regulators, it could trigger the credit default swaps.

I say "could," because depending on how the “credit event” is characterized, it may allow the seller of the insurance to postpone payment for 5 years as well. Just a technical loophole that I am sure most buyers of said credit insurance did not notice.

And even then, I think it's unlikely that many of the sellers of such credit insurance could make anywhere close to the amount of payments they have contracted for. And since the subordinated debt is precisely what you would want to buy credit insurance on, I bet a disproportionate amount of that $62 trillion in credit default swaps is on the lower-rated debt.