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Fed Pushes Fannie, Freddie Shareholders in Front of Train

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Bailout to hit investors hard.

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The effects of this weekend's dramatic power grab in Washington are rippling through the financial markets - and the pundits are arguing about who was right and who was wrong about the Fannie Mae (FNM) and Freddie Mac (FRE) bailout. In the meantime, federal regulators are quietly doing damage control.

Small banks will see large chunks of capital wiped out from equity losses in Fannie and Freddie - but they can now get in line for the government dole.

In seizing the embattled mortgage giants, the Treasury Department shoved common shareholders in front of the train, reaffirming they'd bear the brunt of future losses. As with the Bear Stearns takeover, the Federal Reserve and the Treasury dealt with the moral hazards of risky investments by simply punishing common shareholders and bailing out debtholders.

The countless financial institutions holding Fannie and Freddie preferred stock must now act as the second line of defense for the money of our trading partners, allies and certain well-connected institutional bond investors.

Preferred shareholders have no voting rights, but they stand in front of common shareholders in terms of dividend payments and the right to recover their investments in the event of liquidation. There had been speculation that Washington would go easy on preferred holders and protect their dividends, and, by extension, the value of preferred shares. Since most holders of these assets were other financial institutions, the logic went, the Treasury wouldn't put undue stress on an already troubled group.

The Treasury's bailout plan doesn't protect preferred shareholders, as evidenced by the steep drop in the value of those shares today. However, various financial regulators are prepared to step in and assist small banks with significant exposure to Fannie or Freddie via investments in preferred shares.

FDIC chairman Sheila Bair tried to diffuse the situation by claiming that "Across the industry, banks do not have significant exposure to GSE equity securities." But since the FDIC also neglected to include collapsed mortgage thrift IndyMac on its list of potentially troubled financial institutions just weeks before it went bust, her assertion shouldn't carry much weight.

Sovereign Bank (SOV) isn't likely to be comforted by Bair's soothing words either, as losses on the bank's Fannie and Freddie preferred stock could erase almost a year's worth of earnings, according to analysts at Credit Insights. JPMorgan (JPM) is also likely lose money on similar holdings, although even if it's entire $1.2 billion investment is wiped out, the hit would represent less than 1% of its tangible capital.

Capitalist ideals go right out the window during times of crisis. Unprecedented financial calamities result in unprecedented government intervention.

It's anybody's guess as to how long it will be before markets are allowed to find a true bottom, to experience true price discovery and thus establish a true foundation for recovery. Until then, investors should try to relish being a part of some of the most historic financial events in the past 80 years, while preserving capital for the inevitable opportunities that lie on the ever-elusive other side of the abyss.
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No positions in stocks mentioned.

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