HEARD ON THE STREET No Longer Preferred: A Lesson From Paulson By DAVID REILLY and PETER EAVIS September 8, 2008 Henry Paulson avoided spraying yet more moral hazard onto the financial system. The Treasury Secretary struck the right balance in making sure shareholders in Fannie Mae and Freddie Mac won't benefit from the government's decision to bail them out. Particularly painful was the effective evisceration of the preferred shares. The government suspended dividends on these instruments. Without those payouts, the preferred securities are likely to have little value. Between them, Fannie and Freddie have $36 billion of preferred shares outstanding, many of which were issued recently in a vain attempt to shore up absurdly overleveraged balance sheets. Plenty of the preferreds were bought in the belief that, even though they were equity, they were implicitly backed by the government. In the final stages of the meltdown, there was no shortage of voices calling on the government to back them. But the government did not. And while Mr. Paulson didn't mean that to serve as a wake-up call to preferred holders elsewhere, it should. Too often investors view preferred stock as debt by another name. Those who have loaded up on preferreds from U.S. banks looking to strengthen their capital structure shouldn't forget that preferred shares are equity. Their value can evaporate quickly when a bank issuer hits the skids. Anyone who doubts this should take a look at Washington Mutual's R-series preferreds, issued in December. They now trade at more than 60% below their issue price. The bank sold $3 billion of them, so plenty of investors are sitting on hefty losses. Indeed, preferreds can complicate efforts to support banks, because their dividends consume cash. And in recent months, banks have been forced to offer hefty yields on the securities to lure investors. Weak banks that need to raise more common equity could yet try squeezing preferreds by suspending all discretionary dividend payments. After all, investors will be wary of injecting more common equity if a chunk is going to be paid straight out again to preferred shareholders. Write to David Reilly at david.reilly@wsj.com and Peter Eavis at peter.eavis@wsj.com