(CN) - First dibs on Fannie Mae and Freddie Mac's burgeoning profits in the wake of a $188 billion government bailout belong to the U.S. Treasury, not investors, a federal judge ruled.
The 2008 collapse of the housing market left the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (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 (HERA), authorizing the Treasury to purchase any obligations or securities issued by either company.
The Federal Housing Finance Agency (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.
U.S. District Judge Royce Lamberth in Washington, D.C., is presiding over four lawsuits, including the class action, challenging the third amendment.
Two of the plaintiffs, Hedge funds Perry Capital and Fairholme Funds, says the government acted illegally to have Fannie Mae and Freddie Mac to hand it all their profits.
Lamberth dismissed the actions Tuesday.
"It is understandable for the Third Amendment, which sweeps nearly all [of Fannie and Freddie's] profits to Treasury, to raise eyebrows, or even engender a feeling of discomfort," the 52-page opinion states. "But any sense of unease over the defendants' conduct is not enough to overcome the plain meaning of HERA's text. Here, the plaintiffs' true gripe is with the language of a statute that enabled FHFA and, consequently, Treasury, to take unprecedented steps to salvage the largest players in the mortgage finance industry before their looming collapse triggered a systemic panic. Indeed, the plaintiffs' grievance is really with Congress itself."
Given the unambiguous terms of the HERA, the judge said he was compelled to dismiss all of plaintiffs' claims.
Lamberth noted that the court "does not seek to evaluate the merits of whether the Third Amendment is sound financial - or even moral - policy."
Shares of Fannie and Freddie fell more than 40 percent after Lamberth issued the ruling Tuesday. The plaintiff hedge funds had positioned themselves to make big profits on the corporations in the event of a favorable legal ruling, but their hopes were not rewarded.
Isaac Boltansky, an analyst at Compass Point Research & Trading, told Marketwatch: "Judge Lamberth's ruling represents a material setback for GSE [government sponsored entity] shareholder claims both in court and on Capitol Hill. The focus now turns to ongoing GSE shareholder suits in the U.S. Court of Federal Claims under Judge Sweeny."