Sweating Out A Ruling On Fannie And Freddie

photo courtesy Mark Warner

Summer officially ended for rest of the Northern Hemisphere last week, but a panel of federal appellate judges in Washington still seems to be sweating out a ruling on an Obama administration power-and-money grab left over from the 2008 financial crisis.

The government advanced $187.5 billion to Fannie Mae and Freddie Mac when the mortgages underpinning securities that those government-sponsored entities owned turned sour. Within a few years, however, the housing market rebounded, and so did the value of the government’s investment. By 2013, five years after the crisis peaked, Uncle Sam had collected $230 billion from the two companies, which is a tidy profit for the taxpayers – but a lot more when you consider that as far as the government is concerned, Fannie and Freddie still owe the full $187.5 billion.

If you are trying to work out how $187.5 billion minus $230 billion can equal $187.5 billion, put down your pencil and save yourself a headache. The government deemed the payments it took from the two entities dividends, not loan repayments. And by the government’s reading of the situation, there is no way Fannie and Freddie can ever repay the loans short of liquidation. That’s because in 2012, with a third restructuring of the bailout terms, the government arbitrarily declared itself entitled to every nickel the two companies earn in the form of special dividends.

This would be all well and good if nobody else owned the companies. That is not the case, however. Prior to the crash, Fannie and Freddie were publicly traded, and after the bailout private shareholders were still left with just over 20 percent ownership. This is mainly because the Treasury did not want the obligation of adding the companies’ debt to the federal balance sheet if it simply took over the companies outright. So Treasury left a fraction of the company’s shares in the hands of private shareholders. At some point, these shareholders reasonably anticipated that either the companies would get out from under the bailout debt or that the companies would be liquidated or sold, with the prospect of generating some return for the private owners once the $187.5 billion debt was repaid.

The government’s current position is that those shareholders are entitled to nothing, which makes their shares worth ... nothing. A hedge fund operator that holds shares in the government-sponsored enterprises, Perry Capital, went to court to protest the effective confiscation of its investment. In 2014 a lower court judge had tossed out the case, which Perry Capital then appealed to the D.C. Circuit. A three-judge panel heard arguments in April of this year and a ruling was expected sometime this summer.

Summer has come and gone, but no ruling has been handed down yet. We can only speculate as to the reasons. Some observers would probably attribute political considerations to the judges, but that is no better than a harsh guess. It is also a complicated one, since each of the three judges were appointed by Ronald Reagan, George W. Bush and Barack Obama respectively. Nor did the judges’ questions this spring give observers a clear sense of which way the panel was inclined to rule.

The case centers largely on the 2012 restructuring, which was when the government specified that the government dividends would always equal the quarter’s profits, regardless of whether they were high or low. The government argued that this “net worth sweep” was designed to avoid making the companies’ problems worse; the shareholders argued that the change allowed the government to capture the large profits the companies made in 2013 and 2014.

While Perry Capital LLC v. Lew is arguably the highest-profile case against the government’s treatment of Fannie and Freddie’s private shareholders, Perry Capital not the only shareholder pushing back. According to the Miami Herald, plaintiffs have filed related suits in six states. One plaintiff, the Miami-based mutual fund Fairholme Fund, recently succeeded in gaining access to Treasury Department documents previously kept secret. Fairholme and the other plaintiffs are presumably watching the Perry case with interest – and, at this point, probably with impatience.

The fate of Fannie and Freddie has been fraught with politics for years – so much so that the administration that took office just as the crisis was getting underway is preparing to leave without ever deciding what it wants to do with Fannie and Freddie. There are many who would just as soon see the government get out of the mortgage finance business altogether, but that might all but kill the traditional 30-year fixed-rate mortgage. Banks would much rather lend for shorter terms at variable market rates, which is much more profitable. There are some who see Fannie and Freddie as a valuable instrument of government policy to promote homeownership among middle- and working-class families. On the other hand, it was a relaxation in the companies’ underwriting standards that helped feed the housing bubble in the first place.

So the Obama administration’s approach has been to just treat the two government-sponsored enterprises as cash cows, providing an endless supply of milk. The government could offer to buy out the private shareholders, which is what any other similar takeover would require, but that would mean bringing all of Fannie and Freddie’s obligations onto the government’s books, making explicit that all future housing market risk belongs to the American taxpayer. That is not a position Team Obama has been prepared to take. All it is prepared to take, it seems, is the money: all of the money, indefinitely.

Was the money grab legal? Maybe the appeals court will give us its view before the leaves fall, or before the election, or before the snow flies around the Capitol dome. Or maybe the topic will still be just too hot to handle.

Editor's note: An earlier version of this post incorrectly identified Perry Capital as a mutual fund, rather than a hedge fund operator. Thanks to our readers who pointed out this error.

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