Next month Fannie Mae and Freddie Mac, the giant enterprises that own or guarantee roughly half of all new mortgages, will hand over $7.2 billion to the U.S. Treasury, paying back more than the entire amount of their bailout. The achievement, which once seemed unimaginable, should be good news for the companies’ many private shareholders. It isn’t. Thanks to astonishingly duplicitous behavior by the federal government, they may never get another dime from their investment.
The story begins in July 2008, when Congress passed the Housing and Economic Recovery Act (HERA), authorizing a new regulator, the Federal Housing Finance Agency, to take over Fannie and Freddie if necessary. The agency did so on Sept. 6, days before the collapse of Lehman Brothers.
At the time, Fannie and Freddie were desperately insolvent due to the bursting of the real-estate bubble—which sent plummeting the value of the large number of risky mortgages they had bought or guaranteed. If an ordinary corporation were in this condition, it would be sold or shut down, and any money recovered would go solely to its creditors.
HERA was intended to make this outcome possible. Previously, regulators had the power to “conserve” the mortgage giants, but not to put them into a receivership, which is used to liquidate troubled financial institutions. The new law added the receivership option, at a time when frustration was high with Fannie’s and Freddie’s abuses of the widespread (and correct) perception that the government would backstop all of their obligations. Not only could the Federal Housing Finance Agency put Fannie and Freddie into receivership; if the regulator determined that the mortgage giants were insolvent—rather than just troubled—HERA required the agency to do so.
And yet, while Fannie and Freddie’s financial condition seemed hopeless, the agency instead put the two enterprises into a conservatorship. The decision was in some respects defensible. The government wanted to honor the millions of guarantees Fannie and Freddie had made to homeowners, and it was worried about winding down the giant companies too quickly. Still, the new law required that companies put into conservatorship be “put in a sound and solvent condition.”
To keep Fannie and Freddie afloat, Treasury injected $85 billion in return for preferred stock with seniority over the existing preferred and common stock, as well as warrants to acquire just shy of 80% of the common (voting) stock. The bailout required Fannie and Freddie to pay a 10% dividend to the government every year. When Fannie and Freddie couldn’t make the initial payments, they sold more preferred stock to Treasury, increasing the government’s investment and the size of the 10% obligation. The government’s stake eventually climbed to roughly $187.5 billion.
By early 2012, Fannie and Freddie started to make money. Lots of it. Thanks to a recovering real-estate market and the absence of any real competitors, their profits would eventually be big enough to pay the 10% dividend to the government and still have profits left over.
In August 2012, Treasury did something truly outrageous: It restructured the deal to make sure that Fannie and Freddie’s other shareholders could never get a penny of these profits. Under the new arrangement known as the Third Amendment, any profits are subject to a “net worth sweep.” In short, the 10% dividend due the U.S. Treasury was changed to 100%—forever.
We now know—thanks to a Dec. 20, 2010, memo from Jeffrey A. Goldstein, then undersecretary for domestic finance to then-Treasury Secretary Timothy Geithner that has just been uncovered in shareholder litigation against the government—that the U.S. Treasury considered cutting off shareholders long before 2012.
Why would Fannie and Freddie agree to the Third Amendment? Answer: The Federal Housing Finance Agency, which had taken the two companies over, agreed on their behalf. The regulator sat on one side of the bargaining table and Treasury on the other—one arm of the government negotiating with another. Treasury insists it was looking after taxpayers’ interests. But it hasn’t explained why it cut private shareholders off when it began to look like they too might benefit.
The net worth sweep was arbitrary—in essence an act of expropriation. Worse, the new arrangement gives the government a strong incentive to maintain Fannie and Freddie’s privileged and dominant position in the mortgage market rather than reforming mortgage finance.
Ideally, the government would undo the 2012 sweep, and perhaps revert to the original 2008 arrangement, as part of a decision about the future of Fannie and Freddie. More likely, the issue will be decided in the courts. A number of Fannie and Freddie shareholders are challenging the sweep as, among other things, an unconstitutional taking of their property.
If they win, as they probably will, Fannie’s and Freddie’s shareholders will fare better than other investors (such as Chrysler’s senior lenders) who have been blindsided by the government’s growing penchant for picking winners and losers, regardless of the law. The courts may thus partially repair the rule of law. A far better approach would be for the government to honor it in the first place.
Mr. Skeel teaches bankruptcy law at the University of Pennsylvania Law School.
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