Legal wrangling over who should keep the hundreds of billions of dollars in profits generated by Fannie Mae and Freddie Mac is heating up, and investors increasingly are betting the government will end up the loser.
Since last summer, the Treasury Department has faced a host of shareholder lawsuits over changes it made in 2012 to the terms of the bailout agreements with the mortgage-finance giants in 2008, when the government seized the firms as they neared collapse. The plaintiffs say that the Treasury wasn't authorized to make the changes--which required Fannie and Freddie to send all of their profits to the Treasury--and that the move amounted to unlawful seizure of private property.
The Treasury "has effectively nationalized the companies and ensured that they will never return to private ownership" using steps that are "plainly unlawful," said Theodore Olson of Gibson, Dunn & Crutcher LLP, at a conference last week. Mr. Olson, who served as solicitor general through 2004, is representing Perry Capital LLC, a hedge-fund firm that filed suit last July.
The government has argued that the plaintiffs don't have standing to challenge its decisions because the rescue legislation barred shareholder claims and that the cases don't have merit. "Treasury committed and provided hundreds of billions of dollars to rescue the entities," the government said in its response last month. "Having gained that benefit, the shareholders cannot credibly claim that the [Constitution] demands that Treasury compensate them further for their investment."
Tens of billions of dollars are potentially at stake because Fannie and Freddie sent more than $130 billion to the U.S. Treasury last year, nearly seven times what would have been owed before the terms were changed. Plaintiffs in the lawsuits argue that those proceeds belong to the companies, not the U.S.
Investors, meanwhile, are betting on the side of the plaintiffs. Some classes of Fannie's and Freddie's preferred stock, a form of senior equity, have doubled over the past six months. While shares are still trading at deep discounts from where they stood before the companies were bailed out, many hedge funds and other speculators began amassing the shares when they traded at even deeper discounts over the past five years.
"Developments in the court cases have been net positive for this trade" because court filings have raised "red flags" over the bailout changes, said Michael Kim, managing director of CRT Capital Group LLC, a Stamford, Conn.-based broker dealer.
About 20 suits have been filed, including two by Bruce Berkowitz's Fairholme Capital Management LLC, a mutual-fund firm. Many of the cases have been consolidated before U.S. District Judge Royce C. Lamberth in Washington, D.C. Investors are also suing the Federal Housing Finance Agency, which entered into the Treasury agreement on behalf of the companies; the FHFA declined to comment.
Mr. Olson said last week that the lawsuits will take "a long time" to play out. "But I believe we are clearly right here, and we will be successful," he said.
Investors and attorneys watching the cases say the government's initial motions to dismiss, filed in January, look vulnerable. Some observers argue that the government's actions are at odds with the goals of conservatorship, the legal process by which the U.S. seized Fannie and Freddie. Unlike receivership, a form of liquidation that carries court oversight, conservatorship charged the U.S. with preserving the firms' assets so that they can one day be returned to private ownership.
But the bailout changes in 2012 made it impossible for Fannie and Freddie to rebuild capital, which according to some shareholders, means the U.S. effectively began liquidating the companies even though it never put the firms into receivership.
"They're trying a novel approach to conservatorship," said David Felt, a lawyer in private practice who headed litigation for the FHFA until 2010. " There's a risk that the court might not buy that approach. I'm not predicting the shareholders will win by any means, but they've got a shot." Mr. Felt informally has advised some shareholders but isn't involved in the litigation.
In the initial bailout agreement in 2008, the U.S. agreed to inject nearly unlimited sums of aid--ultimately around $188 billion--and received in exchange a new class of "senior preferred" shares that initially paid a 10% dividend. It also received warrants to acquire nearly 80% of the firms' common stock.
Because the common and preferred stock wasn't ever wiped out, investors continued to trade them. Some concluded--accurately, it turned out--that Fannie and Freddie had reserved more money for loan losses than they would need, and that they would one day return to profitability.
The Treasury revamped the bailout terms in August 2012. It eliminated the 10% dividend, requiring no payments during periods where the companies reported losses and collecting all of their profits as dividends in profitable quarters. In court filings, the Treasury has said the revamp was needed because of concerns that Fannie might eventually exhaust the aid pledged by the government simply to fund the 10% dividend.
If shareholders successfully argue the dividend changes weren't lawful, it isn't clear whether they will receive damages. One possibility would be that the government reduces the amount that Fannie and Freddie owe, a step that could make it easier for shareholders to eventually be paid when the firms are liquidated or restructured through legislation.
The Obama administration and Congress haven't shown much support for privatization proposals advanced by some investors. The upshot, according to Mr. Felt, is that "if investors are going to get any money out of this, it's going to come out of the courts, and it's going to take years."
Ralph Nader, political activist and consumer advocate
Mr. Nader, who has run for president in four different elections, this month launched "Shareholder Respect," an advocacy campaign to help Fannie and Freddie shareholders "escape financial limbo." Mr. Nader says his campaign is designed to highlight the inconsistent treatment of shareholders in Fannie and Freddie compared to shareholders in other bailed-out financial institutions such as Citigroup Inc. and American International Group Inc.
James K. Glassman, director, George W. Bush Institute
Mr. Glassman, who predicted in his 1999 book "Dow 36,000" that the Dow Jones Industrial Average would triple in value by early 2005, has written in recent months a series of op-eds arguing that Fannie and Freddie should be preserved and allowed to survive. It is a view that is at odds with fellow conservatives at the American Enterprise Institute, a think tank where Mr. Glassman is a visiting fellow.
Charles J. Cooper, chairman of Cooper & Kirk PLLC
Mr. Cooper, who is representing Fairholme Capital Management LLC in its lawsuit against the U.S. Treasury, successfully argued a Supreme Court case in 1996, U.S. v. Winstar Corp., in which the government was found liable for breaching contracts that had caused losses for investors who had bought failing thrifts during the S&L crisis of the 1980s.
Theodore Olson, partner at Gibson, Dunn & Crutcher LLP
Mr. Olson served as solicitor general of the U.S. from 2001 to 2004, making him the government's main advocate at the U.S. Supreme Court during the first term of President George W. Bush's administration.
(END) Dow Jones Newswires
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