Aug. 22 (Bloomberg) -- Midwest Bank Holdings Inc. Chief Investment Officer Don Wiest is wagering U.S. Treasury Secretary Henry Paulson will rescue him from a failing $67 million stake in Fannie Mae and Freddie Mac.

Melrose Park, Illinois-based Midwest and banks from Philadelphia-based Sovereign Bancorp to Frontier Financial Corp. in Everett, Washington, own preferred shares in the beleaguered mortgage-finance companies that have lost more than half their $35 billion value since June 30. Concern that Paulson may step in with a rescue plan that would wipe them out along with common stock investors has sent the securities tumbling.

``I guess we are betting on Paulson,'' Wiest, 54, said. ``We have to believe that his plan carries the day somehow.''

Midwest, an owner of banks in Illinois, has $67.5 million, or as much as 23 percent of its risk-based capital tied up in Washington-based Fannie and Freddie of McLean, Virginia. Moody's Investors Service today cut the preferred stock ratings five levels to the lowest investment grade, citing an increased chance that Paulson will rescue the companies, creating ``greater risk'' that the government-chartered firms may stop paying dividends and adding ``uncertainty with regard to how these preferred securities would be treated.''

Small, regional banks may have the most to lose from the stumbles in Fannie and Freddie, and Paulson may risk bank failures unless he protects preferred stockholders, said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York. The impact on the preferred holders ``may be an important driver'' in Paulson's decisions, Jersey said.

Capital `Implications'

``Any wipeout of the preferreds could have implications for the capital of the greater financial system and these regional banks that might have reasonably precarious capital situations,'' Jersey said. ``You don't want to make that worse if you're the government.''

Paulson, who won approval from Congress last month to pump unlimited amounts of capital into Fannie and Freddie, hasn't said how any rescue may work. While the common and preferred shares initially rose after he announced his plan, that optimism has vanished on speculation that the deteriorating housing market is depleting the companies' capital, forcing Paulson to step in.

Paulson, 62, has provided ``zero clarity on the issue and until the market knows where Hank is going to be in the capitalization structure, then it gets worse and not better,'' said Paul McCulley, a money manager at Newport Beach, California- based Pacific Investment Management Co., which oversees the world's largest bond fund.

Other Banks

Treasury probably will get preferred shares as part of any bailout, eliminating the value of the common shares and causing ``a lot of pain'' for preferred shareholders, who will rank behind the government in payments and may have their dividend cut, according to Friedman Billings Ramsey & Co. analyst Paul Miller in Arlington, Virginia. CreditSights Inc. analyst Richard Hofmann in New York said holders should ``brace'' for a deferral of dividends.

Westamerica Bancorporation in San Rafael, California; Valley National Bancorp in Wayne, New Jersey; East West Bancorp in Pasadena, California; Astoria Financial Corp. in Lake Success, New York; Washington Federal Inc. in Seattle and City National Corp. in Beverly Hills, California, also have disclosed ownership of the preferred shares, according to data compiled by Friedman Billings. Spokespeople for the banks either didn't return telephone messages or declined to comment.

Receivership

The Treasury may wait until Fannie and Freddie's capital is so eroded that regulators can put them into a receivership, said Andrew Laperriere, managing director at International Strategy & Investment Group, a money management and research firm in Washington.

Treasury spokeswoman Jennifer Zuccarelli referred to Paulson's July 22 speech, in which he said Fannie and Freddie's ``stability is critical to financial market stability,'' because their debt is held by banks around the world. She declined further comment.

Fannie Mae's $7 billion of 8.25 percent perpetual preferred shares have declined 51 percent to $11.29 since June 30. They fell 26 percent this week, with the yield rising to 19 percent from 13.9 percent.

Freddie Mac's $1.1 billion of 5.57 percent preferred stock has plunged 59 percent to $7.40 since June 30 and 36 percent this week, pushing the yield to 19.5 percent from 12.3 percent.

The common shares were mixed. Freddie fell 35 cents, or 11.1 percent, to $2.81 in New York Stock Exchange composite trading. Fannie was up 15 cents, or 3.1 percent, to $5.

`Viewed as Safe'

``We bought them when they were viewed as safe,'' Heng Chen, chief financial officer of Cathay General Bancorp in Los Angeles, said of the preferred shares. Cathay has $30 million of Fannie and Freddie securities. ``It's hard to tell now.''

Cathay, whose Web Site says it has been offering financial services to the Chinese-American community since 1962, has fallen 31 percent in Nasdaq Stock Market trading this year. The company wrote down the value of its Fannie and Freddie securities by $3.4 million last quarter. The shares rose 12 cents to $18.22 in New York.

Preferred shares rank one level above common stock in the capital structure, which is used to determine the priority of payment in the event of a bankruptcy. Senior debt holders rank first, then the companies' subordinated bondholders followed by preferreds then equity.

Fannie was created by Congress as part of Franklin D. Roosevelt's New Deal in the 1930s and became a publicly owned company in 1968. Freddie was started in 1970, when the economy was strained by the Vietnam War.

`Every Bank Has Them'

The companies, which own or guarantee about $5 trillion of the $12 trillion of outstanding U.S. home loans, were developed to expand financing to homebuyers by purchasing mortgages from lenders and packaging other loans into securities that they then guarantee. Their charters imply that the government will stand behind the debt. The equity doesn't get the same backing.

Banks bought Freddie and Fannie preferred stock because they can be used as capital that regulators require to cushion against losses on loans. Banks also get a tax break on 70 percent of the securities, making them attractive to own, said Midwest's Wiest.

``These are the only two companies that the regulators have allowed banks to hold in their portfolios,' Wiest said. ``Everybody knows we have them. It seems like every bank has them.''

Sovereign tumbled for four days this week on concern its $632 million stake may be worthless in a bailout. The savings and loan said in July it may take ``significant'' charges on its holdings. Chief Financial Officer Kirk Walters said yesterday the company would have enough capital ``in a worst-case scenario.'' The stock gained 22 cents, or 2.7 percent, to $8.49 in New York Stock Exchange composite trading and is down 19 percent this week.

Ramifications

Frontier owns $5 million of Fannie and Freddie securities. The bank cut its dividend by two-thirds in June, saying the deterioration in the housing market was affecting borrowers. Its shares are down 49 percent this year. Frontier rose 38 cents to $9.50 in Nasdaq trading.

``It's just a hard one to figure right now and second guess what they're going to do,'' Frontier Chief Financial Officer Carol Wheeler said in a telephone interview. ``The ramifications are so big. I think every bank across the country has got some preferreds across their portfolio.''

Shifting the Problem

Paulson must also weigh whether hurting preferred shareholders would cripple the $350 billion market that banks across the country also rely on for financing, said CreditSights' Hoffman. Banks sold $76 billion of preferreds this year to bolster capital after more than $500 billion of credit losses and writedowns.

``My fear is that if the Treasury allows the preferreds to fall to zero, all they're going to do is shift the problem from two entities, Fannie and Freddie, to the 8,000 banks that hold this in their portfolios,'' Wiest at Midwest said. Shares of Midwest, with 539 employees at the end of 2007, are down 63 percent this year.

Wiest said he'd be willing to sell the preferred securities at 70 cents on the dollar. ``I'd take it,'' Wiest said. ``Take it and move on and not look back.''

To contact the reporters on this story: Mark Pittman in New York at mpittman@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net

Last Updated: August 22, 2008 16:49 EDT