Yesterday, the US Supreme Court dealt hedge funds and other big investors a blow when it refused to revive lawsuits challenging the federal government’s capture of profits generated by Fannie Mae and Freddie Mac. This ruling leaves intact a federal appeals court decision from a year ago, which ruled that the investors could not sue the government over the dividend change, known as the “net-worth sweep.”
This method of profit capture was introduced in August 2012 when the federal government changed its initial commitment to these companies, put in place after their bailout in the financial crisis.
The Treasury pumped $187 billion into Fannie Mae and Freddie Mac under what was billed as a conservatorship meant to rehabilitate them following their losses from subprime mortgages in 2008/2009 and, initially, these funds were to be repaid with fixed quarterly dividends. In exchange for the bailout, the government received a particular class of stock that paid 10% dividend along with warrants to acquire nearly 80% of Fannie and Freddie’s common stock for a nominal price. In Aug. 2012, that plan was altered to enable the government to capture substantially all of the companies’ profits. When the change was announced, investors across the country rushed to file lawsuits in an attempt to block the action.
While the Treasury has been able to recoup all of its investment and more from these mortgage giants over the past ten years, the profit sweep has eliminated the capital cushions both firms hold (The Federal Housing Finance Agency, in December, struck a deal with Treasury to allow Fannie and Freddie to retain slim capital buffers of $3 billion each). This means they will have to ask for a taxpayer bailout if anything goes wrong -- precisely what Treasury officials are expecting this year.
Following the GOP's tax reform, both Fannie and Freddie are expected to ask for bailouts following losses. Following the reduction in the federal corporate tax rate, both companies have had to book losses on deferred tax assets on their balance sheet, which are now worthless. Initial Treasury estimates were budgeting for a payment of $4.7 billion for Fannie, which is much more exposed to the deferred tax assets, and $400 million for Freddie. Last week, Fannie reported a fourth-quarter net loss of $6.5 billion after taking a $9.9 billion tax provision. Net revenues declined to $5.5 billion, versus $6.2 billion in the year-ago period.
The ruling from the Supreme Court is a massive blow to some high profile investors that were betting on the shares of Fannie and Freddie to recover. Bill Ackman's Pershing Square Capital Management is the most extensive owner of Fannie and Freddie’s common equity, and John Paulson's hedge fund is also an investor as well as Perry Capital (unclear what happened since the fund is winding down) and Bruce Berkowitz’s Fairholme Funds.
Many other hedge funds own the preferred shares, which technically should be worth more even if common shareholders were wiped out.
However, all is not lost and this ten year saga is far from over.
