Both junior preferred shares and common shares of Fannie Mae and Freddie Mac tumbled on Friday after the Treasury Department released its proposals for getting both GSEs out of conservatorship. However, everything changed on Monday as investors cheered the court’s ruling against the U.S. government and in favor of the plaintiffs in a key court case involving the GSEs.
Court sides with plaintiffs
Bank analyst Dick Bove of Odeon Capital released a report on the court ruling on Monday. He explained that the U.S. Court of Appeals for the Fifth Circuit in Houston ruled narrowly in favor of shareholders.
The court ruled that the so-called "net worth sweep" is invalid as currently written. The net worth sweep swept almost all of Fannie's and Freddie's profits to the Treasury, denying holders of their junior preferred shares any dividends. The court also ruled that the Federal Housing Finance Agency (FHFA), which has been overseeing the GSEs, is unconstitutional as currently structured because its director has been given independence.
Bove quoted one dissenter to describe exactly what the court did: "In this case, plaintiffs are injured by the Net Worth Sweep" — an exercise of executive power unconstitutionally granted by HERA. Plaintiffs lost the value of their investments because FHFA used the Net Worth Sweep to transfer their money to the Treasury."
The court ruled that both President Obama and President Trump endorsed the net worth sweep. The ruling about the FHFA being unconstitutional is especially interesting because it suggests that all actions ever taken by any director of the agency are invalid. The ruling also means that recently appointed director Mark Calabria has no authority to do anything to or with the GSEs.
Bove also believes that the court ruling calls into question the constitutionality of the Consumer Financial Protection Bureau and all the rules it has enacted, including the Qualified Mortgage Rules.
"It appears that the President and Congress have been attempting to eliminate democracy by establishing agencies that are run by Directors with dictatorial powers," he wrote. "At least in the case of the FHFA this will no longer be allowed."
Common and Junior Preferred Market reaction to Friday's Treasury report
Bove also noted that the Treasury report which sent Fannie and Freddie shares tumbling is believed to have been written by Calabria. However, after Monday's court ruling, it sounds like he won't have any influence over the matter. Since the market's reaction to the Treasury report was so negative, it comes as little surprise that Monday's court ruling would trigger such a positive response.
Bove explained that Friday's negative reaction sent a "clear message to the bureaucrats which is 'if there is to be a recapitalization of Fannie Mae and Freddie Mac, shareholders must benefit.'" Clearly, if investors see no path to profit, they won't invest, and it will be impossible for the federal government to release them from conservatorship.
Wait just a minute on that court ruling
The bank analyst also explained that Monday's court ruling is "far from being a ringing endorsement of the plaintiffs' case." Instead, he suggests that the court has merely "shifted the judicial momentum." In other words, it means the government can't count on the federal courts blindly accepting the argument that it can "take whatever steps it chooses because conservatorship status gives it that right." This means the government must base its arguments on case law instead of conservatorship. Of course, Bove isn't a lawyer, but his many years of experience as a bank analyst have given him insight into the situation.
He noted that the court stopped short of eliminating the net worth sweep entirely. Instead, it merely stated that the sweep is not legal in its current form, which could mean changes instead of a total elimination. In explaining why the net worth sweep isn't legal in its current form, Bove did seem quite critical of it.
"This may be due to the fact that the conservator was given the responsibility to restore the financial credibility of the GSEs but instead it destroyed their financial credibility," he explained. "Moreover, it did so by enriching the government at the expense of GSE shareholders. In essence, it used the Net Worth Sweep to take the assets and profits of the GSEs for its own benefit."
Instead of eliminating the sweep, the court remanded it for additional proceeding. Bove said the dissenters strongly argued that both President Trump and President Obama nominated and accepted Treasury secretaries and FHFA directors who support it.
What has happened here is that the court has now opened the opportunity to review the whole concept of the Net Worth Sweep from legalistic points of view," he wrote. "This is a swamp."
What's next for Fannie Mae and Freddie Mac junior preferred Investors?
Ultimately, Bove believes the GSEs will largely be returned to the form they were in before they entered conservatorship, but with "stuffer regulations regarding risk" and "stronger oversights of their actions to insure [sic] that the regulations are followed." He praised Republicans and Democrats for finally starting to work together on a solution they can both agree on.
"I am convinced that privatization will occur in a fashion that makes current shareholders whole and future shareholders able to make money," Bove concluded. "…I am relying on the U.S. court system to uphold the rights of private property holders and the understanding of the legislators that the United States needs a healthy housing industry to have a healthy economy. This means it needs a healthy secondary market for mortgages. This means a healthy privately held [sic] Fannie Mae and Freddie Mac.
He also said that in the current situation, he would still be a buyer of Fannie Mae and Freddie Mac.
This article first appeared on ValueWalk Premium