Fanniegate And What The Treasury Knew

When the Federal Housing Finance Administration (FHFA) did its 2012 “net worth sweep,” which took the profits of Fannie Mae and Freddie Mac and put them in the Treasury’s general fund, the federal government claimed that the move was necessary because the two government-sponsored enterprises (GSEs) were insolvent. Newly unsealed documents indicate that the government was aware that the two entities were not insolvent at all and were poised to make very good profits.

The new information further complicates some already complex litigation. Attorneys and others watching the issue, which has been dubbed “Fanniegate” on blogs and other media, say the documents might help these cases, but questions remain about the future of Fannie Mae and Freddie Mac.

The sweep happened as a result of the “third amendment” change to the conservatorship rules that were part of the bailout agreement between the two GSEs and the U.S. Treasury. In 2013, several shareholders of Fannie Mae and Freddie Mac, mostly mutual funds and insurance companies, filed lawsuits claiming the sweep was an unlawful taking of property without just compensation. While the cases proceeded through the U.S. Court of Federal Claims, The New York Times filed an amicus curiae, or friend of the court brief, to unseal some of the confidential documents.

Among the documents that were unsealed in April of this year was a deposition from Susan McFarland, who had been the chief financial officer of Fannie Mae. According to The New York Times, McFarland had told Treasury officials, a few days before the sweep, that Fannie might soon start to report large profits. Another document shows a chart from the firm Grant Thornton, which served as an advisor to the government, showing Freddie Mac’s financial results, projected profits, and a handwritten note about the profits and about reversing an accounting entry.

“The documents show there was recognition in the Treasury that the companies were returning to profitability prior to the third amendment,” says Michael H. Krimminger, a partner with Cleary Gottlieb Steen & Hamilton LLP in Washington, D.C. “Previously, the argument was the third amendment was necessary to address the need to continue to borrow from the Treasury to pay the 10 percent quarterly dividend originally required. If the companies had returned to profitability, you wouldn’t need the third amendment. The documents show Treasury knew that was the case.”

The law firm represents Investors Unite, a coalition of investors that filed an amicus brief in one of the lawsuits, Perry Capital v. Lew. Krimminger says that the confirmation in the newly unsealed documents that the third amendment sweep was not necessary also confirms another important argument in the case. “These documents demonstrate our contention that the FHFA did not fulfill its obligation to conserve and return to solvent condition the companies,” he says. “That was never the intent and not their goal at any point.”

Krimminger says that as with any litigation, predicting whether Perry Capital and other plaintiffs will win their cases and recover their investments is difficult, but he notes that the suits are important for another reason. “Any time the federal government has to intervene in a crisis, it has to treat the creditors and interested parties of companies fairly,” he says. “The Treasury and FHFA cannot simply ignore the obligations of the statute and act purposely to strip value that would otherwise potentially come to the creditors.”

Other say the documents can help the cases against the government. “They prove the U.S. government knew the companies were going to be massively profitable and then the government took these profits for themselves,” says David Thompson, managing partner at Cooper & Kirk PLLC in Washington, D.C. The firm represents the mutual fund Fairholme Fund in The Fairholme Fund et al v. United States. “We are optimistic and feel we are entitled to win the case, and these documents prove our case. We have been saying this was the largest taking of property in the history of the U.S.”

The government clearly knew Fannie Mae and Freddie Mac were not in a death spiral, Thompson says. Although the GSEs laid off employees in 2010, things looked much better in 2012. “There were multiple indicia, such as the stock prices of home builders,” he says. “In 2012, they were on an upswing. The housing market was coming back, and the government knew it.”

Thompson says the documents were frequently referred to in the April 15 oral arguments for the Perry Capital case. In that federal appeals court hearing, U.S. Circuit Judge Donald H. Ginsburg described the net worth sweep as the Treasury saying it would kill the GSE and “salt the earth so it can never grow back.” That was an apt metaphor, Thompson says. “Capital is the lifeblood of any institution,” he says. “By stripping out all the capital from these two very large companies, it cripples them and puts them in a permanent financial coma.”

As for the documents themselves, Richard Bove, an analyst at New York City-based Rafferty Capital Markets, notes that it helped that the plaintiff asked for only four documents out of about 11,000. “If they had asked for all 11,000 to be released, it would take years for the court to determine which ones,” he says.

Bove adds that the new information does not necessarily mean the shareholders will win their cases. “The government lied, but the court might say, so what, it still had the right to do what it did,” he says. “Maybe the rationale to do what they did was incorrect, but they had the right to do that. They had the right to do whatever they want.”

He believes these are the early stages of what is likely to be an extended battle. The real problem, he says, is the government has mandated that Fannie and Freddie go away (or not be capitalized anymore) on Dec. 31, 2017, but 60 percent of mortgages are owned or guaranteed by the two. “They cannot allow these companies to go away because the economic costs to America would be staggering in the sense that nobody will be willing to make 30-year, fixed-rate mortgages in this country,” Bove says. “The value of houses will go down, and you will wipe out trillions of dollars of consumer wealth. The risk of doing that is enormous.”