Bank Stocks: Fed Timing Losers

NEW YORK ( TheStreet) -- Most of the nation's largest banks saw shares slide on Wednesday, led by Capital One Financial ( COF), which was down 2% to close at $67.93.

The broad indices all pulled back as trading volume remained light and investors continued to worry over the coming tapering of Federal Reserve bond purchases. As part of its monetary stimulus known as QE3, the Fed has been making monthly purchases of $40 billion in long-term agency mortgage-backed securities, as well as $45 billion in long-term U.S. Treasuries. Principal payments received from maturing securities are being reinvested, to keep the central bank's balance sheet expanding at a monthly pace of $85 billion.

The Federal open Market Committee has repeatedly said it will continue the securities purchases "until the outlook for the labor market has improved substantially in a context of price stability." Several presidents of Federal Reserve district banks on Tuesday and Wednesday indicated that a slowing of bond purchases was likely before the end of the year.

Federal Reserve Bank of Atlanta president Joseph Lockhart on Tuesday was quoted by Market News International as saying a slower pace of securities purchases could be announced at any of the three remaining FOMC meetings this year. The next meeting will be held on Sept. 17-18.

The market yield on 10-year U.S. Treasury bonds was actually down five basis points to 2.60% Wednesday afternoon. Investors have pushed the yield on the 10-year up from 1.70% since the end of April, in anticipation of a curtailment of Federal Reserve bond-buying.

The KBW Bank Index ( I:BKX) was down 1% to close at 65.40, with all but two of the 24 index components ending with declines.

Shares of Bank of America ( BAC) recovered from earlier losses, ending with a 1% decline to close at $14.53, after the Justice Department and Securities and Exchange Commission late on Tuesday charged the company with mortgage fraud.

Freddie Ladles More Government Gravy

Freddie Mac ( FMCC) on Wednesday announced second-quarter earnings of $5.0 billion, increasing from $4.6 billion the previous quarter. Freddie also announced it would pay the U.S. Treasury a dividend of $4.4 billion in September. Freddie's shares were up a penny in late trading, to $1.40.

Freddie and its sister mortgage giant Fannie Mae ( FNMA) were taken under government conservatorship in September 2008. Under the modified terms of the bailout agreement, the two companies - known as the government-sponsored enterprises, or GSEs - must pay all profits as to the government, save minimal capital buffers of $3 billion for each company.

The government's preferred state in Freddie Mac totals $72.3 billion, and once the September dividend is paid, Freddie will have paid the Treasury roughly $41 billion in cash dividends.

Fannie Mae hasn't yet announced its second-quarter results. The company in May announced pre-tax earnings of $8.1 billion for the first quarter, but the recapture of a $50.6 billion deferred tax valuation allowance brought net earnings up to $58.7 billion. That set up a $59.4 billion dividend to the Treasury. The government's preferred stake in Fannie is worth $117.1 billion, and Fannie has paid the Treasury cash dividends totaling $95.0 billion.

Under the modified bailout agreement, neither Freddie Mac nor Fannie Mae are allowed to repurchase any of the government-held preferred shares, no matter how profitable the GSEs become and no matter how much in dividends the government receives.

Non-government investors have expressed their irritation with the modified bailout agreement through a series of lawsuits with the hope of recapturing some value, the remote possibility of the government's preferred stake being converted to common shares, as was successfully done as part of the epic bailout of American International Group ( AIG). That bailout resulted in a profit to U.S. taxpayers of $22.7 billion, according to the Treasury.

President Obama in a speech on Tuesday broke years of silence on the GSEs to call for the wind-down of Fannie Mae and Freddie Mac, while still providing a limited government backing for mortgage loan securitization.

This is essentially the approach favored by senators Mark Warner (D. Va.) and Bob Corker (R., Tenn.). The senators in June introduced legislation to wind-down Fannie and Freddie over five years, privatize most of the U.S. mortgage market, while putting in place a limited government backstop in the form of a "Federal Mortgage Insurance Corporation (FMIC), modeled in part after the FDIC." The Federal Deposit Insurance Corp. insures bank deposits by charging premiums to all U.S. banks and savings and loan associations.

FBR analyst Edward Mills, in a note on Tuesday, said the president's speech was likely to be "all but an endorsement of the Corker-Warner GSE reform proposal and would make any efforts at a recap of Fannie Mae and/or Freddie Mac even more unlikely."

Then again, with the Republicans in control of the House of Representatives, the president's support of the Corker-Warner bill could make it even more unlikely for the bill to be passed.

What gives hope to the junior preferred and common shareholders of Fannie and Freddie is that the companies keep booking tremendous profits. Institutional investors holding the shares are braced for a multiyear battle.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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