After taxpayer bailout, should Fannie/Freddie shareholders benefit from their big profits?


Begone! (Bloomberg)

A high-profile Senate bill that would dismantle Fannie Mae and Freddie Mac suffered a blow this week when key Democrats decided not to support the legislation, probably wiping out its chances of advancing to the Senate floor this year.

The measure has enough support to pass the Senate banking committee, which plans to vote on it next week. But the bill's sponsors – Sens. Tim Johnson (D-S.D.) and Mike Crapo (R-Idaho) -- failed to win over the committee's liberal Democrats and secure a larger majority. Without more support, the Senate leadership is unlikely to move the legislation to the full chamber for a vote.

So now, all eyes are on a different Fannie/Freddie battle, one that's playing out in the courts, where more than a dozen investor groups are suing the government to get a share of the companies' profits.  (We wrote about this issue here.)

Cornerstone Macro recently released a rather blunt assessment of the investors' chances of winning. In its paper "Fannie and Freddie Shareholders Have a Weak Case," the research firm clearly sided with the government's legal arguments and concludes that the shareholders are unlikely to prevail. But even if the investors win, they'll still lose, the paper said.

"Shareholders should still probably not expect much, if any, return," the analysis said.

A little background is necessary in order for all this to make sense.

The investor groups are suing to undo an arrangement that the government set up years after it seized Fannie and Freddie at the height of the financial crisis to keep the companies solvent and ward off a meltdown of global financial markets. When the government took over in 2008, it began injecting Fannie and Freddie with cash. In return, the companies issued "senior preferred" stock to the government that paid a 10 percent dividend. But the companies were losing money at the time, and kept borrowing from Treasury to pay the dividend.

In August 2012, the Obama administration put an end to that cycle. It demanded that Fannie and Freddie turn over all their profits in the form of dividends to the U.S. Treasury.  By then, the companies were actually cranking out profits.  They will have sent about $213 billion to the government by next month, exceeding the $188 billion that they received from taxpayers.

Hence, the lawsuits. Big investor groups that scooped up huge amounts of shares on the cheap after the bailout –  including the mutual fund Fairholme Capital Management and the hedge fund Perry Capital -- say the government is unlawfully denying them their rightful share of the profits. They say the government took their private property for public use without compensating them for it.

The Cornerstone Marco paper says that's where the investors' arguments fall apart, and that the courts will most likely recognize that if they ever have to consider awarding damages. Again, Cornerstone does not expect things to get that far since it doesn't expect the investors to win.

But just for the sake of argument, here's the problem for investors as Cornerstone sees it:  "The lawsuits by the plaintiffs implicitly assume that taxpayers should not be compensated for the many special advantages provided by the government without which the companies could not have generated any profits during the past few years.  Put another way, how is it the property of shareholders is being taken without just compensation when all the earnings the companies have accrued in the past couple of years is entirely due to massive government support?"

Cornerstone cites the work of Larry Wall, an economist at the Federal Reserve Bank of Atlanta, who examined the "guarantee" portion of the Fannie and Freddie business. (For a fee, the companies insure mortgages and pay investors should the loans go bad – and that's the guarantee business.) Wall found that 77 percent of  Fannie's single-family mortgage guarantee business is from loans acquired since the start of 2009, after the government took control of the company. In other words, private capital had nothing to do with the revenues generated by that business.  The taxpayer backstop is what made those revenues possible.

In his analysis, Wall also says that the government ultimately agreed to "provide unlimited funds to cover whatever losses were incurred in the future.  Fannie and Freddie and their supporters certainly should recognize that committing to cover losses is valuable even if the losses do not arise."

He goes on to say that the 10 percent dividend that Fannie and Freddie were sending the government initially was favorable for the companies, given their condition at the time, and therefore provided inadequate compensation for the risks that taxpayers bore. "The claim that the taxpayers and Treasury have been fully repaid for their support of Fannie Mae and Freddie Mac is based on an accounting calculation that does not withstand economic analysis," Wall concluded.

Back to Cornerstorne.  It points to another factor that it says the investor groups often miss. Fannie and Freddie also buy mortgages from lenders. To purchase those loans, they borrow money at a cheap rate because of their relationship with the government. They package some of those loans into securities and sell to investors, and they hold others. Fannie and Freddie have been making money on the spread on their mortgages compared to their cost of borrowing money, the Cornerstone analysis said.

"Is any judge likely to rule that the shareholders of these companies have had their property taken from them without just compensation when the formerly insolvent companies in which they won shares have not reimbursed the taxpayers for the extraordinary privilege of borrowing hundreds of billions of dollars at rates close to what the Treasury itself can borrow money?"  Cornerstone asked.

 

Dina ElBoghdady covers housing policy for The Washington Post.
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