The burden carried by the holders of stock in mortgage giants Fannie Mae and Freddie Mac, each operating for nearly six years under federal conservatorship, just got lighter. On July 16, U.S. Court of Federal Claims Judge Margaret Sweeney, in a procedural ruling, held that shareholder-plaintiffs in Fairholme Funds Inc. et al. v. United States are entitled to know material facts that the government wants to keep secret. The shareholders are seeking compensation for foregone income resulting from the Treasury Department’s “sweep” rule of August 2012, which forced the companies to forward all dividends to the department in perpetuity. Government lawyers had filed a motion for a protective order on May 30 to inhibit discovery. The outcome of this case will have major implications for the future of property rights in this country.
National Legal and Policy Center has been following the situation at the Washington, D.C.-based Federal National Mortgage Association (“Fannie Mae”) and the McLean, Va.-based Federal Home Loan Mortgage Corporation (“Freddie Mac”) following the federal takeover of the two publicly-traded companies in September 2008. The nation’s financial services industry at the time was in free fall. House prices were plummeting. Defaults and foreclosures were on the rise. And Fannie Mae and Freddie Mac, which now guarantee or hold a combined $5 trillion in U.S. residential mortgages – almost half of outstanding loan volume – had become dangerously undercapitalized. There was a real danger that the holders of their bonds, known as mortgage-backed securities, would not be repaid. An independent federal regulatory agency created by Congress that summer, the Federal Housing Finance Agency (FHFA), used its authority several weeks later to seize the companies and place them under conservatorship. Conservatorship was intended as a temporary measure. The purpose was to keep Fannie and Freddie, as “Government-Sponsored Enterprises,” solvent, thus ensuring timely payments to bond investors. The arrangement was not permanent.
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Over the next few years, the Treasury Department provided the companies with a combined $187.5 billion in loans. The money came out of government-held senior preferred stock representing 79.9 percent of shareholder equity. This bailout came attached with some heavy strings. Most significant was a requirement that Fannie Mae and Freddie Mac had to forward 10 percent of their accrued dividends to the Treasury Department. As their share prices were depressed at the level of penny stocks, their earnings depended on dividends. But during 2011-12, the housing market, unexpectedly and for various reasons, made a comeback. The Treasury Department, seeing an opportunity to speed up debt collection, developed the “third” or “sweep” rule. Issued on August 7, 2012, it would supersede the 10 percent rule. It effectively barred shareholders from realizing any profits on current or future earnings. In the department’s own words, the sweep refers to “every dollar of profit that each firm earns going forward.” Investors were righteously angry. And given that hedge funds and other financial intermediaries held much of their stock, a spate of lawsuits seemed inevitable. Over the course of 2013, they materialized. One of the most publicized of these suits was filed by the New York-based equity fund, Fairholme Capital Management. The action sought to rescind the sweep amendment and to compensate shareholders. This case eventually incorporated similar ones.
On merit alone, Fairholme and co-plaintiffs have a very strong case, especially at this point in time. During Second Quarter 2014, Fannie Mae and Freddie Mac already had sent more than $200 billion in profits to Treasury, a total that was set to rise to $213.1 billion by the quarter’s end – about $25 billion more than what the government had loaned them. To retain the rule would appear in direct contravention with the very purpose of the FHFA conservatorship. Forcibly diverting company profits to the government in perpetuity, argued the plaintiffs, was the antithesis of the intent of the Housing and Economic Recovery Act of 2008 (HERA), which authorized the conservatorship as a temporary measure. Indeed, this was little short of de facto nationalization. The Treasury Department has countered that the plaintiffs have failed to make a convincing case for a regulatory taking.
But there is a reason why the plaintiffs have had difficulties on this score: lack of access to information. The government over the years has kept secret its decisions regarding Fannie Mae and Freddie Mac. And when details of that decision-making are made publicly available, they validate suspicions that the Treasury Department has never had any intention of abiding by the terms of the conservatorship. In late 2013, a New York hedge fund, Perry Capital, filed a separate suit to rescind the sweep rule. Unlike Fairholme, the plaintiffs in that case are not seeking financial compensation. Representing Perry Capital, the Washington law firm of Gibson, Dunn & Crutcher somehow managed to acquire a Treasury Department internal memo, dated December 20, 2010 (see pdf), sent by Undersecretary Jeffrey Goldstein to Secretary Timothy Geithner. In discussing Fannie Mae and Freddie Mac, the memo referred to “the administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future.” In no way did the Treasury Department notify shareholders of this policy change. Had it done so, it is highly unlikely anyone would have continued to hold stock in these companies.