Everything Banks Need to Know About the GSE Shareholders' Lawsuits

WASHINGTON — A powerful group of shareholders is amplifying attacks on housing finance reform legislation as they await resolution of a major legal battle, attempting to slow momentum on the bill before it likely passes the Senate Banking Committee.

Several big hedge funds that stand to possibly win billions of dollars for their shares in Fannie Mae and Freddie Mac are leading the charge, both in federal court and in the court of public opinion.

New investors' rights groups said to be backed by the funds have popped up in recent weeks attacking legislation by Sens. Tim Johnson, D-S.D., chairman of the Senate Banking Committee, and Mike Crapo, the panel's top Republican.

Their presence is yet another complicating factor in the tumult ahead of a scheduled April 29 vote by the committee, potentially hurting efforts to secure additional support for the measure.

"Now that different people have come out with their bills, it's been laid bare that the people working on [government-sponsored enterprise] reform aren't going to do major favors for the shareholders," said Jeb Mason, a managing director at Cypress Group. "As a result, the shareholders have adjusted their strategy to muddy the waters — and, if they can, kill the Johnson-Crapo bill."

Below we offer several frequently asked questions about these new groups, the pending court cases, and what's at stake.

Why the sudden flurry of activity?

Detractors have stepped up their efforts in recent weeks because the Johnson-Crapo bill is headed toward a committee vote.

The legislation, which builds on earlier work by Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., has already curried broad bipartisan support from members of the committee, but banking panel leaders will need to attract additional votes if the legislation is to have sufficient momentum to make it to the Senate floor this year.

Opponents are trying to raise questions about the need for reform and stress its impact on investors and the public in order to hurt that effort.

At issue is the Treasury Department's treatment of Fannie and Freddie stock since the mortgage giants were put into conservatorship in the fall of 2008. The GSEs were initially required to pay 10% on the government's stake each year, before Treasury altered the terms of the shareholders' agreement in 2012, imposing a sweep on all company profits.

Shareholders, including those at big funds like Fairholme Capital Management and Perry Capital Management, argue that the government unfairly changed the terms of the agreement, tapping into returns due to junior preferred and common shareholders.

But recent legislative efforts aren't proving any friendlier to shareholders.

The Johnson-Crapo bill codifies the profit sweep, known as the third amendment to the Senior Preferred Stock Purchase Agreement, and mandates that GSE profits be maximized for the government, which holds senior preferred shares. A rival House bill by Rep. Jeb Hensarling, R-Texas, chairman of the House Financial Services Committee, also codifies the provision.

By comparison, a discussion draft released by Rep. Maxine Waters, D-Calif., the ranking member on the panel, remains silent on the issue of the third amendment and includes a waterfall provision for the distribution of GSE profits, a decision that surprised some observers.

"The bill recognizes the need to create certainty during the transition from the old housing finance system to the new one. Therefore, it would codify a waterfall that would guide how Fannie Mae and Freddie Mac's assets would be distributed upon their liquidation," a Waters spokesman explained.

What have the shareholders been doing?

As part of their effort, investors have begun taking their concerns public through new tax-exempt groups in Washington. The investors argue they were on the receiving end of a rotten deal from the government, particularly those that bought the stocks before the enterprises were put into conservatorship.

"The hedge funds have this incredibly sophisticated, multi-pronged strategy — lawsuits, legislation, academics on the payroll, funding anonymous PR campaigns, offering to buy the companies. They're coming at it from all angles," said David Reiss, a professor at Brooklyn Law School.

It's not entirely clear how or whether any of the individual efforts are coordinated, but the sheer number of groups forming, along with the sophistication of the initiatives, has led many observers to suspect that the big hedge funds, or perhaps wealthy backers of the funds, are involved to some degree.

Tracking the funding stream is difficult, however, because the groups are not required by law to disclose their donors. The groups have portrayed themselves as working for smaller investors like retirees, rather than for big hedge funds that mostly entered the market with speculative trades after the enterprises were in conservatorship and the stock prices had tanked.

"The hedge funds have likely realized they're not doing themselves any favors by making millionaire money managers the face of the cause," said Isaac Boltansky, an analyst at Compass Point Research & Trading. "Hedge funds are one of the least sympathetic groups on Capitol Hill."

Can you name any of these groups?

The Coalition for Mortgage Security, led by Ken Blackwell, a former housing official under President George H. W. Bush, notes on its website that reform "must benefit and treat fairly current and future homeowners, taxpayers, and investors across the country."

The group says it promotes replacing the GSEs with private companies and protecting the 30-year mortgage, while also reiterating concerns about ongoing shareholder claims.

"The rule of law is the basis for American capitalism and must be acknowledged and respected in order for properly functioning capital markets," the website says. "This is the cornerstone for attracting private capital to any market, especially the housing finance market. The rules of the game cannot be changed in the middle of an inning."

A second group, Investors Unite, led by Tim Pagliara, a former investment manager, has also come onto the scene in recent weeks, pushing instead for the recapitalization of the mortgage giants, including the return of affordable housing goals.

"If you start from a premise that Fannie Mae and Freddie Mac have to go, like Sen. Corker did in his legislation, then you're going to end up with a flawed process," said Pagliara at an April 9 press event that featured remarks from a handful of individual investors from around the country. "It leads inevitably to higher mortgage rates, new taxes in the form of user fees that are embedded, and the process is bad because not all the people have been to the table."

Investors Unite is also affiliated with liberal activist Ralph Nader, who started advocating on behalf of investors last fall under his new project, Shareholder Respect. Like Pagliara, Nader has been pushing for the recapitalization of Fannie and Freddie, to the benefit of shareholders.

"The GSEs were certainly not blameless for transgressions similar to those larger ones committed by the Wall Street crowd prior to the financial crisis in 2008. But to eliminate them and unravel this intricate market further, could open the door wide for runaway corporate exploitation," Nader said in an April 9 letter to Johnson. "We don't argue that the GSEs should be maintained as is; but instead that they should be strongly regulated to prevent their previous missteps and abuses, and that shareholders should be allowed to participate in any future recovery."

The move to derail the legislation has also started to show teeth. The 60 Plus Association, a conservative seniors group that has not historically spoken out on housing issues, recently launched a series of attack ads against many of the sponsors of the Johnson-Crapo bill, comparing it to President Obama's health care law. The ads were targeted against seven members of the Banking Committee, including Crapo and Warner, both closely involved with the legislative process, along with Sens. Joe Manchin, D-W.V., Kay Hagan, D-N.C., Dean Heller, R-Nev., Mark Kirk, R-Ill., and Jerry Moran, R-Kan.

"First it was Obamacare — millions of Americans had health plans cancelled. Now Mike Crapo is teaming up with Barack Obama to take over the mortgage industry," one of the ads proclaims. "Under the plan supported by Crapo and Obama, ordinary investors, teachers, police officers, fire fighters, could lose retirement savings."

How effective has the effort been?

So far, it's unclear what impact, if any, investors' campaign will have on the outcome of the bill. This is particularly true if, as analysts have predicted, the bill does not advance beyond the Senate this year. Whether or not the legislation will even have enough support to win a vote on the chamber floor is unknown at this point.

Still, Michael Bopp, a partner at Gibson, Dunn & Crutcher, which represents the hedge fund Perry Capital in one of the ongoing cases, suggested that Johnson and Crapo may be considering rolling back the existing shareholder language in their bill during the upcoming markup to at least be more deferential to the ongoing court cases. Crapo has publicly said he wants to leave the matter to the courts, though the legislative language has been interpreted as going further than that.

"There's growing recognition of language in Johnson-Crapo that people had not fully appreciated the import of — language that needs to come out if members of Congress want the situation to be determined by the courts," said Bopp. "There's a decent chance that you'll see a fix to this language in the chairman's mark when it comes before the committee. I don't think the intention behind this language was to disenfranchise all non-government stakeholders in the GSEs, and yet that's one way it can be read."

A Banking Committee spokesman declined to comment. 

Still, analysts suggested it could be an uphill battle for the investors to get their message across to lawmakers successfully.

"The members are not disingenuous when they say let the courts decide, but they have a preferred outcome for how to use the resources of the enterprises," said Edward Mills, an analyst FBR Capital Markets, noting that the Johnson-Crapo bill calls for using funds from the GSEs to get a new housing finance system up and running.

And some of the efforts, such as commercials comparing GSE reform to Obamacare, could even turn lawmakers more strongly against shareholders.

"The 60 Plus commercials are far more aggressive than any mortgage finance messaging we have seen to date," said Boltansky. "There is a fear that by targeting specific Senators, these ads could push certain members from apathetic to antagonistic regarding the GSE shareholder cause."

There have also been rumblings that industry groups supportive of the Johnson-Crapo bill could start coming out more publicly in favor of the legislation in advance of the markup next week to offset some of the negative chatter around the bill. While the legislation is said to have the backing of the White House and many in the industry, there hasn't been a strong, public charge making the case for why housing finance reform is necessary.

What's going on in the courts?

Given that the Johnson-Crapo bill is unlikely to be signed into law this Congress, the critical backdrop for investors remains the ongoing court proceedings.

Investors, including Fairholme and Perry, along with individual shareholders and other groups, have filed more than a dozen lawsuits in the U.S. District Court for the District of Columbia and the U.S. Court of Federal Claims since last summer, claiming that the government's decision to sweep all of the profits from the GSEs was illegal.

The plaintiffs are employing numerous legal strategies, arguing that the government violated the so-called takings clause of the Constitution's fifth amendment, harmed the value of the stocks, failed to follow the Administrative Procedures Act and exceeded its authority under a 2008 housing law.

Investors won an initial victory earlier this year in the federal claims court when a judge granted shareholders the right to seek evidence until July before the judge rules on the government's motion to dismiss the case. Preliminary briefings are still underway in the DC District Court.

Given the size and complexity of the cases, it's likely to take years before the matter is resolved entirely. Analysts have suggested that if both sides continue to push the issue, it could even rise up to the Supreme Court over the next several years.

"You're talking about many-year or potentially, decades-long lawsuits," said Reiss. "The stakes are humongous and the parties are incredibly sophisticated and well financed. The government parties' incentives to settle are not the same as a private party — I could imagine them seeing this all the way through."