Broken Promises to Fannie and Freddie Investors

Earlier this month, D.C. District Court Judge Royce Lamberth threw out a lawsuit brought against the government by shareholders of Fannie Mae and Freddie Mac. Some critics of the housing giants have hailed Judge Lamberth's finding against investors as a win for American taxpayers — but nothing could be further from the truth. The case has further shaken the confidence of investors who aren't sure what to expect next from a government that has often acted unilaterally and unpredictably in dealing with the recent financial crisis.

In a stunningly misguided opinion, Judge Lambert dismissed the two core claims that had been brought by plaintiffs: first, that the Federal Housing Finance Agency was illegally taking profits from Fannie and Freddie shareholders; and second, that the siphoning of these profits was a violation of FHFA's duty as conservator.

It's worth a quick recap of the history behind this litigation. Congress passed the Housing Economic and Recovery Act in 2008, authorizing emergency loans to Fannie and Freddie and establishing a framework for FHFA to take over the housing giants.

Believing Fannie and Freddie to be insolvent, the FHFA placed them into conservatorship. As part of the conservatorship agreement, the United States got senior preferred shares in both companies as well as the right to purchase 79% of the common stock. The government's preferred shares paid a 10% dividend to the government. Four years later, as Fannie and Freddie were becoming profitable again, the FHFA enacted a Third Amendment changing the terms of the government's preferred stock from a 10% dividend to a 100% sweep of all of the profits — in perpetuity. Shareholders promptly sued.

In the conclusion of his ruling, Judge Lamberth conceded that it would be understandable for the amendment "to raise eyebrows" before suggesting that the plaintiffs' grievance really ought to be with Congress for enacting HERA in the first place.

It's ironic that Judge Lamberth would point the plaintiffs back to the HERA statute, because it provides no basis at all for his ruling. Congress specified that the FHFA's responsibility as conservator was to "take such action as may be necessary to put [Fannie and Freddie] in a sound and solvent condition," and to "preserve and conserve [their] assets."

The dividend sweeps required by the Third Amendment are completely at odds with this "preserve and conserve" mandate and have prevented Fannie and Freddie from rebuilding capital, even though both have become hugely profitable. Since 2008, they have paid back more than $218 billion to the Treasury, about $30 billion more than they were loaned in the first place. It is estimated that the government's right to acquire 79% ownership of the common stock is worth another $200 billion or so.

But perhaps the most astonishing portion of Judge Lamberth's ruling was his contention that shareholder rights were "extinguished" by the conservatorship. By law, a conservatorship merely suspends temporarily certain shareholder rights until the company leaves conservatorship. The conservatorship of Fannie and Freddie is no different.

Congress expressed in HERA its desire to maintain the GSEs as private shareholder-owned companies. In addition, the FHFA itself said this about shareholder rights when it placed the GSEs into conservatorship: "by statute, the powers of stockholders are suspended until the conservatorship is terminated. Stockholders will continue to retain all rights in the stock's financial worth, as such worth is determined by the market."

Not surprisingly, the plaintiff in the suit before Judge Lamberth will appeal the ruling. Other GSE shareholder cases are also active and further along in the process. For instance, Judge Margaret Sweeney has awarded discovery to Fairholme Funds in the U.S. Court of Federal Claims in an entirely separate case. This may produce information about what the government knew about the future profitability of Fannie and Freddie when it decided to enact the sweep.

These cases will eventually be resolved one way or another, but there is a larger issue at hand. The federal government, by acting arbitrarily in imposing the unlawful sweep, has sent a clear message to private capital: There's only downside to being the government's partner in a time of crisis.

As a former chairman of the Federal Deposit Insurance Corp., I find this is deeply concerning. The ability of the FDIC and Federal Reserve to act decisively and effectively in a time of financial crisis is dependent on their ability to engage the private sector in solutions.

When I headed the FDIC, the widespread banking and savings and loan crises were threatening to destabilize the world's financial system. The FDIC and Federal Reserve worked with countless financial institutions and private investors to help stabilize the industry and prevent the crisis from raging out of control. Private capital stepped up, often with little or no time for due diligence, because investors could trust the United States to keep its word.

The government's behavior during and after the most recent financial crisis is having the opposite effect. By changing the rules in the middle of the game, the government has not only violated its responsibility as a conservator, it has undercut the FDIC's and the Federal Reserve's ability to work effectively with private capital in future crises.

Private capital won't show up when the rule of law is subverted, as it has been so dramatically in the case of Fannie and Freddie. The government's actions are wrong and terribly short-sighted; if not reversed, they will come back to haunt us during the next crisis.

William M. Isaac, a former chairman of the Federal Deposit Insurance Corp., is senior managing director and global head of financial institutions at FTI Consulting. Isaac and his firm provide services to many clients, including some who may have an interest in this litigation. The views expressed are his own.