Small banks hobbled by Fannie, Freddie

NEW YORK – Sept. 30, 2008 – Charles E. Allen Jr. took pride in leading the only independent bank based in Johnson City, a northeast Tennessee town with a rich history in railroads, mining and old-time music.

Twelve years ago, Mr. Allen, a former state legislator whose roots in the region date to the nineteenth century, joined 100 families to raise money for State of Franklin Bancshares Inc. Shareholders include local business owners, doctors, schoolteachers and a firefighter.

Now the bank, an unexpected victim of the mortgage meltdown, is being forced to sell out to an out-of-town rival. “I’ve never been so disappointed,” says Mr. Allen, the bank’s chief executive and chairman.

Unlike Washington Mutual Inc. and other failed giants, community banks such as Franklin tend to favor conservative lending practices, so they might have expected to gain market share amid the widening financial crisis. But some small banks have a big problem: They invested – in some cases, heavily – in the preferred stock of mortgage behemoths Fannie Mae and Freddie Mac, which were recently taken over by the U.S. government. The investments are expected to be worthless.

Camden Fine, president of the Independent Community Bankers of America, says as many as 200 of his 5,000 members have indicated they will have to raise capital because of losses in Fannie and Freddie preferred. He expects a dozen will fail and 40 will be forced to sell to a rival. He says many other banks will see a quarter or even a year’s earnings wiped out. “This could have a chilling effect on credit in many communities,” he says.

State of Franklin wrote off $10 million in Fannie and Freddie preferred shares, about half of its capital. Unable to survive on its own, the savings bank this month agreed to sell to Jefferson Bancshares Inc., about an hour’s drive away in Morristown, Tenn. State of Franklin investors are expected to receive $10 a share, or $10.9 million – exactly the same stock price as the bank fetched at its founding in 1996. At year-end 2007, appraisers had valued the company’s shares at $24.50 apiece. State of Franklin, with $330 million in assets, has six branches and one under construction.

Mr. Allen notes that government officials had repeatedly stressed the soundness of the government-chartered Fannie and Freddie, whose preferred shares were considered so safe they were one of the few types of securities banks could count in their capital base - along with Treasury bonds.

“Our bank has excellent earnings and a very clean loan portfolio,” Mr. Allen says. “The only mistake we made was in owning U.S. government agencies.”

Mr. Allen worries that, as banks lose their hometown roots, Johnson City, with a population of roughly 60,000, will be overlooked. Mr. Allen says his 100 employees often knew their customers, helping them make sound underwriting decisions.

State of Franklin managed to plow a big chunk of its $3 million in annual profits into charitable activities. Reflecting pride in its heritage, the bank took its name from an episode after the Revolutionary War when the region, then part of North Carolina, briefly broke away to form the autonomous State of Franklin.

The bank provided seed money for a pharmacy school at East Tennessee State University, defibrillators for the local police department and funding for a downtown Halloween celebration that attracted thousands of children each year. As of June 30, the latest data available, State of Franklin had a 13.5 percent deposit market share in Johnson City, trailing only large regional banks First Horizon National Corp., Memphis, Tenn., and SunTrust Banks Inc., Atlanta, according to the Federal Deposit Insurance Corp.

“There won’t be the same emphasis on Johnson City in the future as there was in the past,” says Mr. Allen, son of a local physician and grandson of a railroad employee.

A recent survey by the American Bankers Association found that 27 percent of the nation’s 8,500 banks faced combined losses of $10 billion to $15 billion in the wake of the federal government’s takeover of Fannie Mae and Freddie Mac. It wasn’t known how many had written off the losses and how many were still unrealized.

Some are giants. J.P. Morgan Chase & Co. disclosed it holds $1.2 billion in preferred shares and Sovereign Bancorp, $623 million. But the survey found that 85 percent of the affected institutions were community banks – those with less than $1 billion in assets.

The industry is asking for the government to consider paying “a reasonable level” of dividends on Fannie and Freddie preferred stock to preserve some of the shares’ value. The industry also wants the government to be more flexible if the losses cause some banks to fall below federal capital requirements. Proponents of the takeover said the government had to act swiftly to shore up confidence in the financial system, even if it meant wiping out shareholders.

Banks also are seeking tax relief. Because of a quirk in tax law, the banks won’t be able to deduct most of the losses on their Fannie and Freddie holdings on their federal taxes. The financial damages are considered “capital losses” for tax purposes – meaning they can be used as a deduction only against capital gains earned by banks. But few community banks have meaningful capital gains to report. So, in the tentative agreement reached over the weekend in the massive financial bailout, Congress plans to let banks deduct the losses from ordinary income, cushioning the blow.

Samuel Caldwell, a banking analyst with Keefe, Bruyette & Woods Inc. in Atlanta, says 43 of the roughly 200 publicly traded banks he examined have exposure to Fannie and Freddie preferred stock, amounting on average to 4 percent of capital – in most cases, not enough to fall below regulatory thresholds. Regional and community institutions holding preferred shares on average owned $18 million worth.

But for $2.1 billion-in-assets Gateway Financial Holdings Inc., the exposure ended up deciding the bank’s future. The Virginia Beach, Va., bank, which has 37 branches, faced $40 million in losses from its Fannie and Freddie preferred stock. Because of that hit, the bank last week agreed to sell itself to smaller Hampton Roads Bankshares Inc. in Norfolk, Va., for about $100 million. The deal is contingent on Gateway raising an additional $30 million in capital.

The losses “are going to take a lot of energy away from the lending effort,” Mr. Gibson says.

In New York City, Moses Marx faced a tough decision. The 73-year-old chairman of Berkshire Bancorp, who owns almost 55 percent of the company, was forced to write down the value of $86 million in securities related to Fannie and Freddie. The move wiped out most of Berkshire’s capital. Otherwise, the bank has a rock-solid balance sheet, with a negligible percentage of nonperforming loans.

The $1 billion-in-assets bank, with a dozen branches, has its roots in Borough Park, Brooklyn, the heart of New York’s orthodox Jewish community. Mr. Marx, an orthodox Jew himself, fled Nazi Germany in the 1930s with his family, and made his fortune in the securities and real-estate businesses.

Although Berkshire’s headquarters is in the shadow of the Federal Reserve Bank of New York’s headquarters in lower Manhattan, Mr. Marx says that he, unlike many on Wall Street, doesn’t expect government help. To keep Berkshire afloat Mr. Marx has decided to invest $60 million of his own money in the bank. He wonders why more captains of industry aren’t stepping forward to put up capital at their institutions. He figures he will make the money back over time.

“We have a duty to our customers, our shareholders and our employees,” Mr. Marx says. “We’re making it good without question. I can’t face myself not doing this,” Mr. Marx says. “How would I get up in the morning?”