The financial rescue package that was largely agreed upon before the candidates rode into town would have negated a “devastating tax consequence” that had been hanging over small banks’ heads since the Treasury Department placed Fannie Mae and Freddie Mac into conservatorship. Treasury’s action crushed the value of the GSE preferred stock, which is held by many financial institutions, including small banks and corporate credit unions.

Federal regulators quickly offered assurances that they were prepared to work with these institutions to develop capital-restoration plans under existing capital regulations and the agencies’ prompt corrective action provisions.

That’s all well and good, but as the agencies reminded bankers, their investments in preferred stock and common stock with readily determinable fair value must be reported as available-for-sale equity security holdings. Any net unrealized losses on these securities should be deducted from regulatory capital. No matter how you cut it, being blindsided by a huge capital hit is the last thing a banker needs in the current environment.

Moreover, the agencies apparently underestimated the extent of the problem. After Treasury announced the conservatorship, the agencies said that, while many institutions hold common or preferred shares of Fannie and Freddie, only a limited number of smaller institutions have holdings that are significant compared to their capital.

Since then, an American Bankers Association industry survey found nearly 27 percent of banks hold preferred Fannie or Freddie stock. Also, 3.4 percent of banks hold auction-rate securities backed by the preferred stock. The average exposure to banks’ core capital was 11 percent.

“The negative impact on banks — particularly Main Street community banks — is far greater than the regulators first thought,” ABA President and CEO Edward Yingling said in a letter to Treasury Secretary Henry Paulson and the four federal banking regulators. “The impact on capital from the Fannie and Freddie preferred stock write-downs will restrain even the best banks in this country from making new loans,” Yingling added.

The Independent Community Bankers of America also sought tax relief. “Community banks cannot offset this huge forced loss on their tax returns because these preferred stocks represent capital gains and losses, not ordinary gains and losses,” ICBA President and CEO Camden Fine told Treasury officials.

“Since bank regulators explicitly do not allow banks to invest broadly in stocks (save for stock of certain government-sponsored enterprises), community banks simply have no viable capital gains in stocks to offset the losses on the Fannie/Freddie preferred stock caused by Treasury’s conservatorship action. ICBA doubts Treasury, bank regulators, or any policymaker ever intended this perverse, destructive net tax consequence forced by government action.”