US banks face losses after giant mortgage bail-out

Dozens of small regional banks in the US could be plunged into financial difficulties as a result of the government bail-out of Fannie Mae and Freddie Mac.

Many banks hold preferred stock in the two mortgage giants, and the suspension of preferred stock dividends was part of the small-print of yesterday's game-changing announcement by the US Treasury.

With the federal government taking a $1bn stake in the company via the issue of new superior preferred stock – which ranks above the ordinary and preferred shares already in existence – current holders last night faced uncertainty over the value of their investments.

The banking industry regulator, the FDIC, said that institutions that were adversely affected should get in touch if they feared that losses on preferred stock eroded the capital cushion required to protect depositors.

"Any negative impact will be narrowly focused only on a few smaller institutions. Regulators will be working closely with those few banks to develop capital plans to assist their recovery," the FDIC's chairwoman, Sheila Bair, said in a statement.

The FDIC takes over banks that fall into financial difficulties, and last Friday assumed control of the 11th such bank so far this year, Silver State Bank of Arizona, where the Republican presidential candidate John McCain's son Andrew served on the audit committee until July.

The suspension of dividends under Fannie Mae and Freddie Mac's new regime – which establishes a "conservatorship" under the control of the federal government – was ordered to prevent the impression that the government was bailing out existing investors, rather than acting more widely to protect the economy.

The plan, widely expected in financial markets since the Treasury promised in July to do whatever it takes to keep Fannie and Freddie afloat, was given a guarded welcome by many market participants yesterday.

In particular, investors welcomed the Treasury's decision to step in as a buyer of mortgage-backed securities issued by Fannie and Freddie, thus providing direct liquidity to the mortgage markets. Gummed-up credit markets have hurt demand for mortgage-backed securities and contributed to the cascade of losses through other kinds of mortgage derivatives. Direct government purchases should ease the burden on investment banks, whose mortgage investments have plunged in value and forced half a trillion dollars in write-downs since the credit crisis began.

Until now, the Federal Reserve, the US central bank, has been the conduit for federal intervention in the MBS market, taking these securities in as collateral for loans to investment banks.

Ben Bernanke, Fed chairman, said yesterday: "I welcome the introduction of the Treasury's new purchase facility for mortgage-backed securities, which will provide critical support for mortgage markets in this period of unusual credit-marketuncertainty."

A Treasury spokesman said it will buy $5bn of mortgage-backed securities issued by Fannie and Freddie from the open market this month, but left open the question of how much support it might ultimately provide.

That is likely to depend on conditions in the credit markets and the duration of the housing market slump, which triggered the credit crisis in the first place. The Treasury's decision to invest directly in mortgage-backed securities and to seize control of Fannie and Freddie effectively turns it into one of America's biggest mortgage lenders – an unprecedented situation with unpredictable consequences.

Andrew Harding, director of taxable fixed income at Allegiant Asset Management in Ohio, said the move put a floor under the credit crisis. "The reality is that some action like this needed to be taken. What you will see is a tremendous rally in mortgage-backed securities, which in turn will help other credit-related spreads. This will take all credit spreads narrower. This is certainly a very, very big step to fixing the credit markets."