Fannie Mae and Freddie Mac investors are turning their focus to an appeal and multiple pending lawsuits after a federal judge rejected their bid for a share of the companies' profits.
The appeal of the U.S. district court order on Sept. 30 in Washington, affirming the U.S. Treasury's right to earnings of the bailed out mortgage giants, stands little chance of winning, according to five legal scholars. They disagree on the prospects for similar cases before the nearby Court of Federal Claims, where Judge Margaret Sweeney has allowed plaintiffs to collect information about the companies from the government.
"I do not believe she will shut down her case," said Richard Epstein, a law professor at New York University. "But you can never be sure."
U.S. District Judge Royce Lamberth dismissed the claims of investors including Bruce Berkowitz, the head of Fairholme Capital Management LLC, and hedge fund manager Richard Perry's Perry Capital LLC. The judge found that the government is allowed under a 2012 amendment to the companies' bailout agreements to sweep "nearly all" profits from Fannie Mae and Freddie Mac to the Treasury.
Perry Capital filed its notice to appeal the ruling yesterday. At least $33 billion — the face value of potentially worthless preferred shares in the companies — is at stake.
"The district court's decision overlooks important points of law and improperly resolved key questions of fact,'' Theodore B. Olson, Perry Capital's attorney, said in an emailed message. "The merits of this case deserve to be heard in court.''
More than a dozen related cases remain, with investors claiming that they've been improperly barred from participating in post-bailout profits earned by Fannie Mae and Freddie Mac. The companies, which were seized by regulators in 2008 as they neared bankruptcy, package mortgages into guaranteed bonds. They required $187.5 billion in taxpayer funds to stay afloat before they returned to full-year profitability in 2012 as the housing market rebounded.
Several suits in the Court of Claims, including one filed by Fairholme, allege Treasury and the Federal Housing Finance Administration, which regulates Fannie Mae and Freddie Mac, agreed between themselves to take dividends owed to the companies' shareholders, in an illegal "taking" under the U.S. Constitution. The Court of Claims hears cases against the government.
The investors may have no better luck on appeal or with the other claims, said Peter Henning, a law professor at Wayne State University in Detroit.
"This was always a huge gamble," Henning said, referring to the lawsuits. "You're dealing with a decision of a federal agency as to how a bailout should be handled. The choices were a government bailout or your holdings were worth zero."
The Court of Claims suits aren't likely to prevail, Henning said. "They're coming up against a constitutional issue," he said. "The U.S. has sovereignty and the government was the lender of last resort."
Investors' confidence that they'll be saved either in the courts or Congress can be seen in Fannie Mae and Freddie Mac shares still carrying market values of about $18 billion after their rout this week, according to data compiled by Bloomberg, which includes the government's right to take 80% stakes in their common equity. The slump since the court ruling has erased a total of about $17 billion of value.
The Senate Banking Committee approved a bill in May that would replace Fannie Mae and Freddie Mac with a government insurer of mortgages. The full Senate didn't vote on the bill, which some Democrats opposed.
"To still be a holder you have to still believe in congressional action on" reform of Fannie Mae and Freddie Mac, Isaac Boltansky, an analyst at Compass Point Research & Trading LLC, said in an interview with Bloomberg Television. "But making a bet on congressional action seems very tough in this political climate."
Investors are challenging the arrangement in which the Treasury takes all of Fannie Mae and Freddie Mac's quarterly profits. The practice, known as the third amendment, began in 2012, replacing an earlier deal in which the two companies paid a quarterly dividend as a return on the U.S. bailout.
Treasury was authorized to "purchase any obligations and other securities issued by" Fannie Mae and Freddie Mac, a provision which also allowed it to "exercise any rights received in connection with such purchases," Lamberth wrote in his ruling.
The third amendment "requires Fannie Mae and Freddie Mac to pay a quarterly dividend to Treasury equal to the entire net worth of each" entity, minus a small reserve that shrinks to zero over time, Lamberth said.
The Third Amendment may "raise eyebrows, or even engender a feeling of discomfort," Lamberth wrote in his decision. "But any sense of unease over the defendants' conduct is not enough to overcome the plain meaning" of the text of the law under which the rescues were permitted, he said.
Jim Vogel, a debt analyst at FTN Financial, said in a note to clients that "although various legal scholars may disagree with the judge's reasoning, it rings true on a larger stage. Private capital invested in a government-sponsored enterprise always runs the chance of disappearing with a change in government policy."
Lamberth dismissed the Fairholme lawsuit too quickly and looked at the dispute too narrowly, Epstein, the New York University professor, said. "He pulled the nuclear option."
Epstein consults with hedge funds that have investments in Fannie Mae and Freddie Mac. He said he has no role in the litigation or the funds' investment strategies.
Lamberth compared the FHFA's role with that of the Federal Deposit Insurance Corporation during the savings and loan crisis of 1989, where the FDIC was granted "enormous discretion" to act as a conservator or receiver. This discretion "applies with equal force to the mortgage finance crisis of 2008," Lamberth said in a footnote to the decision.
"The judge found that 'enormous discretion' covered it, so we don't have to look at the fairness of the deal," Epstein said. "He didn't decide the case on the merits."
Judge Sweeney, who is overseeing lawsuits in the Court of Claims, may look at the issue differently, Epstein said.
"Judge Sweeney thinks that what Judge Lamberth found to be irrelevant is relevant. She has been granting more requests for information" in the Fairholme lawsuit in federal claims court, Epstein said.
This includes allowing Fairholme and other plaintiffs the right to seek details from the U.S. on the prospects for future profitability for Fannie Mae and Freddie Mac and "whether the FHFA acted at the direct behest of the Treasury," Sweeney said in a Feb. 26 order.
Reversing Lamberth's decision is unlikely, as appellate judges would hesitate in interfering with regulators' ability to act decisively, said John Coffee, law professor at Columbia University in New York. "There's a fear that financial regulators could not act quickly in a financial crisis," he said.
Portions of Lamberth's decision may be vulnerable on appeal, said Steven Davidoff Solomon, professor at the University of California at Berkeley School of Law, including the judge's rejection of the plaintiffs claim that there was a "conflict of interest" between Treasury and FHFA.
"His reasoning on why there was no conflict is unpersuasive," Solomon said. "Treasury was clearly controlling what was going on here."
That doesn't mean the investors will ultimately win on appeal, he said. The U.S. Supreme Court may decline to take the case, because the government could lose billions of dollars through a reversal, he said.
Fairholme vowed to fight on after the Lamberth decision.
"Although litigation is a lengthy process, shareholder- owned Fannie Mae and Freddie Mac remain vitally important and increasingly valuable to all constituents," Berkowitz's firm said in a statement. "On behalf of hundreds of thousands of Fairholme Funds shareholders, we will vigorously pursue the enforcement of existing contractual claims and our inalienable rights of property ownership as guaranteed by the U.S. Constitution."
