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Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies in conservatorship that are retaining earnings since September 2019. There are two major plaintiff legal challenges that I am looking forward to seeing results from later this year. The first is Michael Rop v. FHFA that is in the sixth circuit and the second is Fairholme Funds v. FHFA that is scheduled for trial in October. Prior Board Chair of Fannie Mae Sheila Bair says the GSEs should exit conservatorship and FHFA just finalized a stress test that shows how the capital requirements are possibly a route to overcapitalizing Fannie and Freddie – something prior CEO of Freddie Mac Don Layton would agree with. I want to highlight that Alec Mazo put together a superb analysis on the ongoing recapitalization efforts of Fannie and Freddie and how far we have come and how far we have left to go. With that in mind, I wanted to offer two major legal catalysts and a bit more background on what appears to be people jockeying for position for a potential government loss on the legal front that may lead to admin driven restructuring as a means to accelerate their paths out of their respective conservatorships.
Investment Thesis
The ROP v. FHFA lawsuit could result in a legal ruling that unwinds the net worth sweep that could put common shares between $5-8. Further, if FHFA adjusts its capital requirements, which I don’t think it has to and probably will not, but it should, the price of commons could be worth over $10 in a restructuring. If FHFA were to lower its capital rule it could provide more support for equal opportunity affordable housing on an ongoing basis through Fannie and Freddie as well as generate more immediate funding via a higher valuation of its restructured equity stake. For common shares to have upside, they need to have the net worth sweep reversed in a court ruling. Preferred shareholders, however, have many other paths forward where they can be made whole or close to it if the companies are recapitalized and restructured and turned into public utilities.
ROP v. FHFA – In Appeals Court
In September 2020, a judge dismissed all the claims. The judge sidestepped the appointments clause claim by categorizing it as a political question and saying therefore it is not justiciable. Plaintiffs appealed to the Sixth Circuit Court of Appeals and filed their opening brief in December 2021. The case was argued orally June 9th for plaintiffs by Pete Patterson in front of Justices Gibbons, Cook and Thapar. Pete Patterson, before going to work for Cooper and Kirk, where he is representing shareholder plaintiffs in this case, served as a law clerk for Judge Jeffrey Sutton in the Sixth Circuit Court of Appeals. This legal ruling is expected to be announced sometime in the next 90 days as it was orally argued in front of the appeals panel over two months ago.
Ed DeMarco went to work at FHFA from Treasury and became Acting Director in September 2009. There, he helped solve Treasury’s 2012 budget issue by implementing the net worth sweep in 2012 as acting director three years after becoming acting director. The argument could be made that the Senate would have never confirmed a director who would have used housing funds to fund Treasury’s general obligations to offset increased executive spending on Obamacare. Congress is supposed to oversee approving the government’s budget. In this case, the president appears to have gone around the intention of Congress using an acting director that Congress would have not confirmed to take funding action that Congress would not have approved.
Therefore, the appointment’s clause argument that ROP plaintiffs are making is interesting because it is designed to safeguard from this very sort of thing, whereby the president would just choose people to run Federal agencies that are not confirmable to do whatever he wants them to do while he nominates people who he knowingly could not get confirmed anyway because they’re too controversial to get through the Senate confirmation process. The appeals court seems to understand that the government’s argument promotes a rogue run around the intention of Congress.
The Judges Seem To Favor Plaintiffs
All three of the judges in the panel seem to disagree with the lower court’s ruling that the Appointments Clause challenges have no merit because there is no time frame after which an acting director is no different than a senate confirmed director. The 3-judge panel seemed to argue that the lower court ruling does not reconcile with their interpretation of the law.
Does The Appointments Clause Mean Anything?
Judge Thapar said to the government lawyer:
But then what does Ryder mean when they say we want to encourage people to bring appointments clause challenges? What would be the point if we always applied de facto officer doctrine. The court would say ‘bring something you can never win.’
On top of seeming to agree with shareholder plaintiffs’ interpretation of the law, the judges seem to think that the government lawyer’s desired oral arguments are without merit, as analyzed below.
Is The Government Just Making Excuses?
At 24 minutes into oral arguments Judges Cook and Gibbons start questioning what the government’s defense is “It’s like these two arguments look for excuses to not consider the core issue, sort of fringe things… are you conceding?”
The defense’s lawyer Gerard Sinzdak goes on to saying that “if your honors are interested in avoiding that question…” to which the judge interrupts “well what if we are?” The Treasury lawyer then replies saying, “Well then we would urge your honours to hold …” to which the judge interrupts again, “well why don’t you make that argument.” The government’s lawyer goes on to argue that there is no limit to the tenure on an officer.
Trouble With The Government’s Argument
Judge Thapar points out the trouble with the government’s argument:
What really troubles me about your position is the theory is the president can have actings forever and we never need to go through the Senate confirmation process and that can’t be what the Appointments clause means.
…
For this office they (congress) have not placed a limit, for this office from now until the end of time: can presidents appoint people through the acting process and they can fulfill the roles, the functions of a principal officer without ever having Senate confirmation?
The government lawyer answers that “Yes is the answer to your question.” So you have a Judge saying that his interpretation of the Appointments clause appears to necessitate that directors go through Senate confirmation and that if he should agree with the government’s defense he would be supporting a process that undermines this process to infinity and this poses a significant theoretical problem.
The government’s lawyer continues, “It is a theoretical issue, but it is one that has not happened in reality.” Judge Thapar replies, “Well, DeMarco served over three years… presidents nominate people they know they can never get confirmed, you could keep your person in office in theory. You could keep someone politically unacceptable, politically unaccountable by doing it this way and avoid Senate confirmation.”
And that’s the problem with the government’s argument and for that reason the ROP v. FHFA Appeals court decision is worth paying attention to and it can be expected in the next 90 days and could very well reverse the net worth sweep because it was done by an acting director (Ed DeMarco) over two years after he became director.
For the judges to side with the government’s defense here, it would largely render the appointment’s clause meaningless and devalue the long standing Senate Confirmation process. For this reason, I am optimistic about plaintiffs’ chances with this pending appeals court ruling.
Fairholme v. FHFA – Set For Trial In October
Judge Lamberth has been ruling in favor of the plaintiffs interpretation of the law since the case was remanded back to him after he originally dismissed everything. Trial is currently scheduled to start middle of October. This puts a meaningful ruling to be expected in November. I have previously outlined the strength of these legal claims. I see these claims as largely beneficial to preferred shareholders but not as significant for common shareholders as they do not put the net worth sweep back into the box, per se. Fannie Mae common shares aren’t even included in the breach of contract claims. Based on the recently released pretrial statements, a ruling against the government’s motion for summary judgment now would appear to have significant meaning for preferred shareholders. This motion has been fully briefed for months.
Shareholders’ Pretrial Statements
Shareholder plaintiffs have filed their pretrial statements. Exhibit A has 15 pages of discovery that plaintiffs’ lawyers have selected as relevant for this trial. Presumably these documents show that the government and related parties all knew and planned well in advance about the pending reversal of the deferred tax assets that were previously written down as part of retroactively justifying the conservatorship using FHFA’s discretionary accounting authority by forcing Fannie and Freddie to write down their assets 2008-2011.
Plaintiffs’ Expectations Informed Based On Public Statements
Plaintiffs argue that they reasonably expected the companies to eventually be able to build capital based on public statements from FHFA:
On September 6, 2008, FHFA placed the Companies into conservatorship. The conservatorships did not modify any contractual rights held by the Companies’ investors. Indeed, FHFA expressly stated that Fannie’s and Freddie’s stockholders “continue to retain all rights in the stock’s financial worth,” and FHFA’s then-Director testified to Congress that “shareholders are still in place; both the preferred and common shareholders have an economic interest in the companies” and that “going forward there may be some value” in that interest. FHFA explained to investors at the time that the conservatorships were “intended to have a limited duration” and the “objective” of the conservatorships was to “return the entit[ies] to normal business operations.” FHFA publicly stated that the conservatorships would last only “until [the Companies] are stabilized” and promised that once the Companies had been restored to a “safe and solvent condition,” “the Director will issue an order terminating the conservatorship.” These statements were consistent with the text of HERA, which charged FHFA as conservator with “preserv[ing] and conserv[ing] [the Companies’] assets and property” and managing them in a manner that would restore them to a “sound and solvent condition.” See 12 U.S.C. § 4617(B)(2)(D).
The biggest evidence plaintiffs have going for them is that the government admitted in emails produced and made public via discovery in other cases that there is no scenario where it would make less under the third amendment net worth sweep than it would have without it (10%), that the government expects to make more under the third amendment net worth sweep, and that it ensures that private shareholders never see a penny of profits:
This so-called “Net Worth Sweep” also completely eliminated the private shareholders’ ability to realize the benefits of their contractual rights to dividends and liquidation distributions. Internal Treasury documents demonstrate that the purpose of the Net Worth Sweep was to ensure that all future income from the Companies would be paid directly to Treasury, leaving nothing for the private shareholders.
Discovery has already been produced publicly in other lawsuits that support plaintiff arguments. Government internal documents support the narrative that the government saw huge profitability inbound and arranged the net worth sweep so that it could try to continue to wind down the enterprises and take 100% of everything moving forward leaving shareholders with nothing.
Plaintiffs’ Proposed Damages Models
The document includes proposed verdict forms where the jury writes down expectancy and restitution damages. My understanding is expectancy damages would leave the preferred shares outstanding and restitution would be payment to clear them entirely from the capital structure. Plaintiffs can only get one of the two, not both. Expectancy damages pay out in aggregate 47% of par – and the dividend terms of the preferred securities would appear to matter for this one:
This method seeks to measure the net present value of future dividends that Fannie Mae and Freddie Mac shareholders would have earned but for the Net Worth Sweep based on Prof. Mason’s conservative assumptions. Under this method of expectancy damages, assuming no periodic commitment fee, damages are $10.321 billion for owners of the Fannie Mae Preferred, $5.887 billion for owners of the Freddie Mac Preferred, and $11.002 billion for owners of the Freddie Mac Common. In a scenario where the Court determines that a periodic commitment fee would have been imposed, damages are $9.357 billion for owners of the Fannie Mae Preferred, $5.337 billion for owners of the Freddie Preferred, and $9.288 billion for owners of the Freddie Mac Common.
Presumably, as part of resolving the litigation with an expectancy damages win, the government would have to resolve its SPSPA. Fannie Mae common do not participate in damages here, but Freddie Mac common and both Fannie and Freddie preferred do. For restitution damages, however, common shares don’t seem to participate in damages at all. For restitution damages, it appears the primary thing to look at is how much of a percent of par the preferred you own have paid out in their history and that is your basis for calculating damages:
Plaintiffs would receive the present value as of August 2012 (the date of the Net Worth Sweep) of the sums initially paid for shares (“issuer-received cash flows”), and Fannie Mae and Freddie Mac would receive the present value as of the same date of dividends it paid since issuance (“purchaser-received cash flows”). Damages are equal to the issuer-received cash flows minus the purchaser-received cash flows, which amounts to $16.337 billion for owners of the Fannie Preferred prior to the application of prejudgment interest and $26.939 billion after the application of prejudgment interest, and $11.809 billion for owners of the Freddie Preferred prior to the application of prejudgment interest and $20.989 billion after the application of prejudgment interest.
Preferred shares have been issued at different times, with some only having paid a single dividend before they were placed into conservatorship (OTCQB:FNMAT). These ones would have the largest percentage of par payout in a restitution model.
Government’s Pretrial Statements
The government has filed its pretrial statements. The government points out in their proposed jury instructions that Fannie and Freddie would be liable to pay damages to shareholders, not the federal government:
The payment of any damages award that you make in this case will be the sole responsibility of Fannie Mae and/or Freddie Mac. Neither FHFA nor the Director of FHFA nor the federal government will have any responsibility for the payment of any damages award in this case.
The government argues that the net worth sweep saved the companies from a potential death spiral:
By executing the Third Amendment, FHFA as Conservator eliminated the risk that paying dividends to Treasury would erode Treasury’s Commitment and furthered the public interest in a stable secondary mortgage market. The Third Amendment guaranteed that each of the Enterprises would never again draw money from Treasury just to make their quarterly dividend payments. This ensured that the Treasury Commitment, capped as of January 1, 2013, would be available to backstop the Enterprises’ operations during quarters in which either of the Enterprises incurred losses. Maximizing the amount of the Treasury Commitment available to cover potential future losses maximized the ability of the Enterprises to survive in stress case scenarios. It was reasonable for the Conservator to consider and plan for stress scenarios and guard against downside risk from future financial downturns that could threaten the stability of the secondary mortgage market. Thus, FHFA’s execution of the Third Amendment on behalf of each of the Enterprises was a reasonable action to promote the public interest in a stable secondary mortgage market.
Further, the government argues that plaintiffs arguments that the net worth sweep harmed enterprises’ shareholders are without merit:
Finally, Plaintiffs cannot prove that FHFA’s execution of the Third Amendment harmed the Enterprises’ shareholders. Plaintiffs contend that, absent the Third Amendment, the Enterprises would have begun paying dividends to private shareholders at some point between 2026 and 2057—that is, dividends would not have commenced until decades after the Third Amendment. This theory is based on a chain of speculative assumptions, without record support, each of which would be required to be met before dividends could be paid. These include that the Enterprises could have met their pre-Third Amendment obligations to Treasury (i.e., 10% dividends and periodic commitment fees) while at the same time building the necessary capital. Plaintiffs further assume, without basis in the record, that the Enterprises would have begun paying down Treasury’s liquidation preference in January 2013, despite (A) the express prohibition of paydown in the PSPAs, and (B) the fact that when FHFA asked Treasury to allow the Enterprises to begin paying down the liquidation preference as their finances permitted, Treasury did not agree. Any suggestion that Treasury would have changed its mind by January 2013 has no basis in the record and is pure speculation. Because Plaintiffs cannot prove with reasonable certainty that the Third Amendment caused the shareholders not to receive dividends, their implied covenant claim fails.
The government’s argument sounds pretty scary, but it helps to review the context of Judge Lamberth who previously ruled on these claims to see what he ruled. His previous ruling favors the plaintiffs’ narrative as outlined in the next two sub-sections.
Judge Lamberth: Shareholder Plaintiffs Could Not Have Reasonable Expected The Net Worth Sweep
Judge Lamberth previously ruled that if the plaintiff’s narrative proves true then they have valid legal challenges:
And at this stage of the litigation, the claim that Defendants’ discretion was not reasonable is plausibly supported by the factual averments from the various plaintiffs’ complaints, including that:
- at the time the Third Amendment was enacted, the GSEs, FHFA, and Treasury understood that the GSEs were about to achieve sustained profitability, Class SAC $§ 51-56; Fairholme FAC $$ 55-67; Arrowood FAC $J 51-63,
- the GSEs and FHFA knew this profitability would permit the GSEs to pay the 10% dividend without the necessity of drawing from the Treasury, Class SAC $$ 52-53; Fairholme FAC $$ 69-70; Arrowood FAC $} 65-66,
- the Third Amendment permitted the Treasury to reap enormous benefits in exchange for no new investment, Class SAC $ 60; see also Perry I, 70 F. Supp. 3d at 224; Robinson v. Fed. Hous. Fin. Agency, 876 F.3d at 234, and
- the Third Amendment guaranteed that Plaintiffs would never receive dividends or liquidation distributions, e.g., Class SAC $$ 12-14; Fairholme FAC; Arrowood FAC.
The Court finds nothing in the Plaintiffs’ stock certificates suggesting they could have reasonably expected the Net Worth Sweep.
The US Treasury invested $0 and in exchange for $0 it got all the future profits of Fannie and Freddie and that agreement is called the third amendment net worth sweep. Plaintiffs argue that it is a breach of implied covenant of good faith. Judge Lamberth seems to agree at this point should plaintiffs’ arguments hold up against the facts produced by discovery.
Judge Lamberth: Plaintiffs’ Facts Support A Finding Government Acted Unreasonably
Judge Lamberth ruled that based on the narrative the plaintiffs argue that the plaintiffs have brought a valid legal challenge:
But Plaintiffs claim that this was merely pretextual. Plaintiffs allege that—at the time of the Third Amendment—the FHFA and the GSEs knew:
- the GSEs would “be generating large revenues over the coming years, thereby enabling them to pay the 10% annual dividend well into the future” (Class SAC $ 53; Arrowood FAC $ 64; Fairholme FAC $ 69);
- the GSEs’ profits would be “in excess of current 10% dividend paid to Treasury” (Class SAC $ 53; Arrowood FAC $ 67; Fairholme FAC 71);
- 2012 through 2020 would be the “golden years of GSE earnings” (Class SAC $ 54; Arrowood FAC $ 53; Fairholme FAC $ 56); and
- by 2020, cumulative dividends paid by the GSEs to Treasury would exceed Treasury’s total investment (Class SAC $ 54)
The pleaded facts not only show that the GSEs would not need to draw on Treasury’s funds to pay dividends, but also that the GSEs could repay Treasury for its investment under the pre-Third Amendment dividend structure. Such facts could support a finding that Defendants exercised their discretion arbitrarily or unreasonably.
For years, the Court of Federal Claims has produced documents providing these quoted statements that Lamberth was sourcing whereby the government knew it was seizing the GSEs profits when enacting the net worth sweep as opposed to helping the companies or saving them from a downward spiral. These discovery documents have been used to make plaintiffs arguments strong enough for Judge Lamberth to rule that the case will move forward to trial.
Judge Lamberth has been ruling that if the shareholder plaintiffs’ facts produced by discovery support their narrative which argues their contracts were breached by the net worth sweep. This bodes well for them as they head to trial in October 2022.
Prior GSE Officials Weigh In
Situs AMC’s Tim Rood Sheila Bair, former Fannie Mae Board Member, on his podcast where she explained that it is time for the GSEs to exit conservatorship:
Because entrenched conservatorship – the government pretty much controlling finance in the country – how long does that last? So I do think it’s a real problem, it’s a real risk, and one of the reasons why I support an exit. I think it’s time for the GSEs to exit
Sheila speaks to the reality that FHFA is now a political agency and that it is difficult to run Fannie Mae and Freddie Mac with leadership direction changing every presidency as well as the difficulty in retaining top talent while in conservatorship.
Donald Layton, prior Freddie Mac CEO, has also recently written that the capital rule that FHFA created for Fannie and Freddie is too large. Layton argues that the conservatorship has no end in sight and completely ignores the pending litigation that makes it impossible to attract and raise new money. He does, however, acknowledge that everyone is on board with the continued retention of earnings and argues that with that in mind an off-ramp needs to be designed that results in a utility model.
FHFA Stress Test
The Federal Housing Finance Agency (FHFA) published their 2022 Dodd-Frank Act Stress test results. In their severely adverse scenario, Fannie and Freddie still make money. Graham Fisher analyst Josh Rosner says this stress test highlights that the FHFA capital rule is 100% politics and not related to risk.
In my opinion the main difference that changed between now and pre conservatorship is that the guarantee fees that Fannie and Freddie charge have roughly doubled. If you can imagine an inner tube that is inflating via pump and stayed arguably fully inflated and resurfaced after someone pushed it under water (2008 housing crisis) is now taking on twice as much air via inflation (doubled guarantee fees) – it just makes it that much harder to sink the inner tube. Fannie and Freddie have been changed from reasonable businesses that price their fees at a small premium to their actual risk to cash generating machines that now price their fees twice as high and the market STILL cannot compete with their pricing. That’s pricing power at its finest brought to you by economies of scale.
Maxine Waters – What about $150B For Housing?
Maxine Waters is the Chairwoman of the Financial Services Committee and she pushed for $150B in the Build Back Better Act for housing and she is disappointed:
However, there is not one nickel, not one dime, not one dollar, for the development of housing in this bill.
We can no longer afford to have housing as an afterthought, a ‘nice to have,’ or simply something that can wait until later. It is foundational to the prosperity of families, key to a healthy economy, and crucial to fighting inflation. Yes, I’m disappointed. I’m going to vote for this bill because so many people are going to benefit in different ways, but I’m disappointed that housing does not show up in any way in this bill.
Maxine Waters wants additional funding for housing. This funding could come from monetizing the government’s equity position in Fannie and Freddie and the aforementioned legal catalysts could incentivize this kind of admin action.
Summary and Conclusion
There are a handful of legal challenges moving forward, but my two favorites are the ROP and Fairholme lawsuits and I expect major legal rulings later this year on both. Prior GSE officials are pushing for the continued retention of GSE earnings and are advocating for an off-ramp so that Fannie and Freddie can exit conservatorship. FHFA stress tests say that Fannie and Freddie would be overcapitalized in their severely adverse scenarios. Members of Congress want funding for housing and Treasury’s equity position in Fannie and Freddie has been valued at over $100B.
Owning preferred shares has roughly the same amount of upside as common shares albeit with significantly less risk as there are more paths to being made whole than just legal victories that order the government to unwind the net worth sweep. All things considered, there is a lot of momentum heading into the next 90 days where a lot of this 10-year saga of legal battles is set to be largely decided. It might be argued that everyone is setting up for the government to lose one of these legal battles at which point it would choose to move forward with monetizing its equity position.
It seems like everyone is slowly moving into a position of needing $100B+ for housing and pushing for Fannie and Freddie to be a utility model. The last major step for this to happen is restructuring their balance sheets and the government seems like it needs a legal ruling against their net worth sweep in order to move forward on this front.
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