Investors Lose Battle for Post-Bailout Profits

(CN) – In the wake of a $188 billion government bailout of Fannie Mae and Freddie Mac, the Federal Housing Finance Agency had the authority to divert the mortgage giants’ future profits to the U.S. Treasury, a divided D.C. Circuit ruled Tuesday.

The 2008 collapse of the housing market left the Federal National Mortgage Association, also called Fannie Mae, and the Federal Home Loan Mortgage Corp., or Freddie Mac, in danger of folding.

To avoid the economic disaster that such a collapse would create, Congress enacted the Housing and Economic Recovery Act, authorizing the Treasury to purchase any obligations or securities issued by either company.

The Federal Housing Finance Agency, abbreviated as FHFA, placed Fannie and Freddie under conservatorship in September 2008, and committed $100 billion in funding to each corporation.

A second amendment raised the limit to $200 billion each, in exchange for a dividend worth 10 percent of the Treasury’s existing liquidation preference.

In a third amendment, the Treasury replaced the previous dividend formula, and simply required that Fannie and Freddie pay the Treasury the amount by which their net worth exceeded a fixed capital buffer, a figure that shrank each quarter.

A class of investors that owned stock in Fannie Mae or Freddie Mac described the amendment as requiring “Fannie Mae and Freddie Mac to pay a quarterly dividend to Treasury equal to the entire net worth of each enterprise, minus a small reserve that shrinks to zero over time.”

When Fannie and Freddie agreed to this amendment in 2012, the Treasury had provided $187.5 billion to the companies.

Fannie and Freddie have since paid the bailout money back and are now hugely profitable, but all those profits go to the government, not to investors.

Four consolidated lawsuits, led by Perry Capital and Fairholme Funds, lost their challenge to the third amendment before a district court judge in 2014.

A divided three-judge panel of the D.C. Circuit affirmed Tuesday, finding that the Recovery Act gives the FHFA authority to take any action the agency determines to be in Fannie and Freddie’s best interest.

“Entirely absent from the Recovery Act’s text is any mandate, command, or directive to build up capital for the financial benefit of the companies’ stockholders,” U.S. Circuit Judges Patricia Millett and Douglas Ginsburg said in a rare co-written opinion.

It makes complete sense for Congress to enact this legislation, passed in the throws of the worst financial crisis since the Great Depression, to serve the taxpaying public’s best interest, not the best interest of shareholders, the two judges held.

The 74-page opinion continues, “The most natural reading of the Recovery Act is that it permits FHFA, but does not compel it in any judicially enforceable sense, to preserve and conserve Fannie’s and Freddie’s assets and to return the companies to private operation.”

Therefore, FHFA’s authority as conservator permitted it to give the Treasury a preferential right to Fannie and Freddie’s dividends, to the exclusion of other stockholders, the judges concluded.

U.S. Circuit Judge Janice Rogers Brown dissented, finding that the government overextended its authority by treading on investors’ rightful property in a manner that circumvents traditional bankruptcy law.

“The practical effect of the court’s ruling is pernicious,” Brown said. “By holding, contrary to the Act’s text, FHFA need not declare itself as either a conservator or receiver and then act in a manner consistent with the well-defined powers associated with its chosen role, the Court has disrupted settled expectations about financial markets in a manner likely to negatively affect the nation’s overall financial health.”

Fairholme Fund’s Fifth Amendment takings claim is pending in the U.S. Court of Federal Claims.

Hamish Hume, an attorney for the investors from Washington, D.C. law firm Boies Schiller Flexner, said in a statement that shareholders still have an opportunity to show they are “entitled to substantial compensation.”

“While the decision may be viewed as affirming much of what the Government did, in our view the most important ruling in the decision is the one that allows the Class of Fannie and Freddie shareholders to pursue their breach of contract claims for damages,” he said. ” We look forward to presenting those claims to the trial court.”

Hume added, “The dissent by Judge Brown would have allowed private shareholders to advance even more claims, and may give rise to a petition for rehearing by the full DC Circuit, or a petition to the Supreme Court.”