Hedge Funds Can't Sue Over Investments in Fannie or Freddie

A federal appeals court upheld a ruling that barred hedge funds from suing to overturn the U.S. government's 2012 decision to capture billions of dollars in the profits generated by the mortgage guarantors Fannie Mae and Freddie Mac after their bailout, sending shares plunging.

Some Fannie Mae and Freddie Mac investors still have a shot at money damages, based on when they acquired their shares and whether they did so before or after the Federal Housing Finance Agency was created and then imposed its control over Fannie Mae and Freddie Mac. They can pursue breach of contract claims, the appeals panel said in a split 2-1 decision Tuesday.

"It's a little too early for me to announce what our response will be other than to say that these breach of contract claims were always the central claims in this case," said Hamish Hume, a Washington-based attorney with Boies Schiller Flexner LLP, who represented some of the prevailing shareholders.

Fannie Mae shares fell 24% to $3.18 at 11:42 a.m. on Feb. 21 in New York trading. Freddie Mac shares were down 23% to $3.10. Some classes of Fannie's preferred shares were down more than 30%.

Major owners of Fannie's and Freddie's preferred shares include hedge fund manager Perry Capital and mutual fund firm Fairholme Funds Inc. Bill Ackman's Pershing Square Capital Management is a major owner of the companies' common shares.

In place since January 2013, the net worth sweep allowed the U.S. to recapture all of the $187 billion in taxpayer money it spent to stave off the companies' collapse during the global fiscal crisis and — by the end of 2015 — at least $56 billion more. All of that without reducing Treasury's liquidation stake in either firm.

The court, which included two judges selected by Republican presidents and one picked by a Democrat, heard arguments on April 15. It later allowed additional friend-of-the-court briefs to be filed by allies on each side, solicited still more submissions concerning a jurisdictional question and permitted the investors' filing of evidence produced in sweep-related cases pending before other courts.

Their ruling may yet be subject to U.S. Supreme Court review.

The Treasury Department press office did not immediately reply to an emailed request for comment. David Thompson, an attorney for the suing Fairholme Funds Inc. did not immediately respond to a voice-mail message seeking comment.

Lauren Levy, a lawyer at New York-based, Perry Capital, didn't immediately reply to a voice-mail message seeking comment. The firm's outside counsel, Ted Olson at Gibson Dunn & Crutcher LLP, also didn't immediately respond to a request for comment.

Fannie Mae and Freddie Mac provide housing market liquidity by buying mortgages, then bundling them into securities on which they guarantee payments of principal and interest.

Shares of each have soared since the election as President Donald Trump's nominee for Treasury Secretary, Steven Mnuchin, said the new administration would move quickly to end government-control of the companies. Neither Trump nor Mnuchin have specified what they want to do with the companies, but some shareholders have said that they expect Trump to let them share in the companies' profits.

While each has reported an annual profit since 2012, Fannie Mae's and Freddie Mac's earnings power has fallen sharply. In some quarters, the earnings wouldn't have been large enough to meet what would have been owed under the original 10% dividend, a point that government lawyers have said shows that the change in dividend structure was a sound decision. Freddie Mac, for example, has booked a loss in two of the past four quarters.

Sweep terms let the companies retain an annually diminishing capital buffer that phases out in 2018, meaning any losses later sustained will require one or both to draw on taxpayer funds.

In 2008, as the global economic crisis worsened, Congress passed the Housing and Economic Recovery Act, or HERA, legislation that created the Federal Housing Finance Agency and empowered it to take control of the teetering government-sponsored enterprises. At that time, they were guarantors of more than $5 trillion in residential mortgages, about half the U.S. market, according to a government court filing.

Treasury pumped $187 billion into Fannie Mae and Freddie Mac under what was billed as a conservatorship meant to rehabilitate them. Initially, the U.S. was to be repaid with fixed quarterly dividends. In August 2012, that plan was altered to enable the government to capture substantially all of the companies’ profits, sparking lawsuits in Washington, Delaware, Iowa and elsewhere.

U.S. District Judge Royce Lamberth in Washington threw out the Perry/Fairholme case, as well as a related class action, in Sept. 2014, finding HERA blocked most of their claims. Dividends, he said were payable at the discretion of the companies’ directors.

"The plaintiffs' grievance is really with Congress," he said then. "It was Congress, after all, that parted the legal seas so that FHFA and Treasury could effectively do whatever they thought was needed to stabilize and, if necessary, liquidate the GSEs."

Arguing the net worth sweep should be set aside, Perry Capital lawyer Theodore Olson told the appellate panel it was, "a massive, and we submit lawless, expropriation of Fannie Mae and Freddie Mac," that left them insolvent "zombies."

Hume asked the judges to look at the economic substance of what the government had done with what were now profitable businesses. He said those who held Fannie Mae and Freddie Mac stock at the sweep's inception had been materially harmed.

Defending the government's action, FHFA lawyer Howard Cayne told the court Freddie Mac and Fannie Mae were on the brink of insolvency at the time of the bailout. Had the mortgage market failed, "that would have made a horrible situation just so much worse."

In a letter to investors, Perry Capital principal Richard Perry in September said he was winding down his New York-based flagship fund after 28 years, explaining that his investment style no longer worked.

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