FNMA and FMCC NEWS: Fairholme Capital Management

Bruce Berkowitz’s Fairholme Capital Management LLC filed a lawsuit against the U.S. government on Tuesday to challenge changes made last year to the Treasury Department’s bailout agreement with Fannie Mae and Freddie Mac, becoming the second large investor to do so this week.

Fairholme filed suit in the U.S. Court of Federal Claims and said it also planned to do so in U.S. District Court in Washington, D.C. At issue is the government’s decision last year to force the bailed-out mortgage-finance giants to send all of their profits to the U.S. Treasury as a dividend payment.

Perry Capital LLC, a large hedge fund, filed a similar lawsuit in federal court in Washington late Sunday.

Investors first began buying up Fannie and Freddie’s preferred shares—a class of stock that is entitled to a fixed dividend and that is paid out ahead of the common stock—four years ago for pennies on the dollar on the bet that the companies would one day make enough money to pay back the government for its bailout.

Fannie and Freddie were taken over through a legal process known as conservatorship five years ago in order to keep mortgage markets from collapsing. The government agreed to inject unlimited sums to keep them solvent, receiving a new class of “senior preferred” shares for its investment. In exchange, the companies were to pay a 10% dividend, and the government received warrants to acquire up to 79.9% of the firms’ common stock.

Last year, the Treasury Department altered those agreements, requiring the firms to make no dividend payments in periods where they ran a loss and to send any profits to the Treasury as a dividend in profitable quarters. Fannie and Freddie aren’t able to rebuild capital as a result. Also, there is no mechanism for them to redeem the senior preferred shares, leaving no chance for investors to make good on their bets.

“Fairholme’s objective is quite simple,” said Mr. Berkowitz in a statement Tuesday. “The government set the terms of their 2008 investments and should be held to their original deal.”

A Treasury Department spokesman said the government was reviewing the lawsuits. “We fully believe our actions have been lawful and appropriate,” said the spokesman.

Fairholme said it would be represented by the law firm Cooper & Kirk. Perry is being represented by Theodore Olson, the former U.S. solicitor general, of Gibson, Dunn & Crutcher.

Fairholme said last month that it had acquired preferred stock with a face value of $2.4 billion. Perry Capital hasn’t disclosed the size of its investments. The hedge fund, which isn’t seeking damages, said it wants the recent amendments to the stock-purchase agreements to be set aside.