Congress Weighs Tax Relief For Banks Hurt by Fannie, Freddie

Congress is considering giving billions of dollars in special tax relief to banks that suffered losses related to the federal takeover of Fannie Mae and Freddie Mac, ratcheting up the potential cost of the broader Wall Street bailout package.

A provision that would offer the tax relief for banks was included in a memo from the Senate Finance Committee on proposed tax provisions in the bailout. Wednesday, House Financial Services Chairman Barney Frank (D., Mass.) indicated that he supports the idea of assistance for such banks.

The cost of the special tax relief wasn't clear, but it is estimated to be at least $3 billion, most of which likely will be borne this year and next.

The tax issue stems from the roughly $36 billion of preferred stock issued by Fannie Mae and Freddie Mac, two giant institutions that help finance many of the nation's home mortgages. When the government seized control of Fannie and Freddie earlier this month, the value of the preferred stock was nearly wiped out.

Many of the preferred shares were owned by banks, particularly small community banks. Under federal rules, these small banks were severely restricted in the types of investments they could hold but were permitted to buy Fannie and Freddie preferred shares. According to the Independent Community Bankers of America, about 800 of its members owned about $16 billion of Fannie and Freddie preferred instruments.

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The cost of the special tax relief wasn't clear, but it is estimated to be at least $3 billion, most of which likely will be borne this year and next.”

However, 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 losses 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, in part because of the same regulations that limit their stock ownership.

The community bank trade group last week wrote to Treasury Secretary Henry Paulson and members of Congress urging action. "I doubt Treasury, bank regulators, or any policymaker ever intended this perverse, destructive net tax consequence forced by government action," wrote the association's president, Camden R. Fine. The group asked Congress and Treasury to permit its members to record those losses as ordinary, not capital, losses.

The Senate tax proposal would apply to all financial institutions, not just community banks, that own preferred shares of Fannie and Freddie, according to a congressional staffer.

An American Bankers Association survey found that 27% of its banks owned some preferred shares in Fannie and Freddie. The majority of those were community banks. But larger banks also were caught up in the mess. Sovereign Bancorp Inc. owned $623 million of preferred shares of Fannie and Freddie and says it expects to write those down by the end of the current financial period. Wells Fargo & Co. has said it will write down its Fannie and Freddie holdings, and Cascade Financial Corp. has said it expects to.

At a hearing Wednesday, Rep. Frank said that "there is a danger that community banks will be victimized." He argued that community banks were more victims than perpetrators of the subprime lending debacle, and were suffering collateral damage.

The Senate Finance Committee, in its memo released Tuesday, said the tax-relief move would help banks "avoid the need to obtain additional capital from the FDIC or investors. This should also prevent some community banks from becoming insolvent."

The Senate proposal would apply to any preferred stock owned Sept. 6, just before the Fannie and Freddie seizures. It also would include any preferred stock sold between Jan. 1 and Sept 6.