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Fannie Mae, Freddie Mac Plunge After Court Ruling on Profit

Fannie Mae, Freddie Mac Plunge After Court Ruling on Profit

Fannie Mae and Freddie Mac plunged in New York trading after investors including Bruce Berkowitz’s Fairholme Capital Management LLC lost a legal bid yesterday to force the bailed-out companies to share profits with private shareholders.

Fannie Mae fell 29 percent to $1.92 at 11:10 a.m. Freddie Mac dropped 26 percent. Their preferred shares, which drew investments from private-equity and hedge funds, also tumbled, with one series plummeting 54 percent. The mortgage giants had surged for more than two years on speculation that shareholder rights to the earnings could be restored.

The investors sued for breach of contract over allegedly promised dividends and liquidation preferences, and what they called an illegal “taking” under the U.S. Constitution. U.S. District Judge Royce Lamberth rejected their claims, finding that the government is allowed under a 2012 amendment to the companies’ bailout agreements to sweep “nearly all” profits from Fannie Mae and Freddie Mac to the U.S. Treasury.

“Judge Lamberth’s ruling represents a material setback for GSE shareholder claims both in court and on Capitol Hill,” Isaac Boltansky, an analyst at Compass Point Research & Trading LLC, said in a note to investors, using an abbreviation for government-sponsored enterprises.

The lawsuits, among the first of almost 20 related cases to be decided, were filed by investors Berkowitz, who was named Morningstar Inc.’s domestic stock manager of the decade for the 2000s, and billionaire hedge-fund manager Richard Perry’s Perry Capital LLC.

Ackman’s Fund

Investors have claimed they’ve been unfairly barred from participating in post-bailout profits earned by Washington-based Fannie Mae and Freddie Mac. At least $33 billion -- the face value of potentially worthless preferred shares in the companies -- is at stake in the cases, as well as shareholders’ efforts to win congressional support for the idea of reviving Fannie Mae and McLean, Virginia-based Freddie Mac.

Hedge-fund manager Bill Ackman’s Pershing Square Capital Management LP filed a separate suit in August in the U.S. Court of Federal Claims in Washington, claiming the government’s diversion of profits violates the Constitution’s Fifth Amendment, which prohibits the taking of private property for public use without just compensation. Fairholme also has a case in that court that is now in pretrial exchange of information.

Fannie Mae and Freddie Mac each surged more than 1,000 percent in 2013 on speculation that courts or lawmakers would allow private investors to share in the companies’ profits, which have rebounded along with the housing recovery. The mortgage-finance firms extended their rally through July, then lost their gains for the year in September, when they each fell more than 30 percent.

Nader, Pagliara

Along with big Wall Street investors, shareholder advocates such as one-time presidential candidate Ralph Nader and CapWealth Advisors Chief Executive Officer Tim Pagliara, who started a group called Investors Unite with 1,000 members, have argued the U.S. has been unfairly and illegally taking the companies’ profits. They contend the country would be better served by returning them fully to private shareholders.

“Although litigation is a lengthy process, shareholder-owned Fannie Mae and Freddie Mac remain vitally important and increasingly valuable to all constituents,” Berkowitz’s firm said in a statement through Sard Verbinnen & Co. “On behalf of hundreds of thousands of Fairholme Funds shareholders, we will vigorously pursue the enforcement of existing contractual claims and our inalienable rights of property ownership as guaranteed by the U.S. Constitution.”

AIG Dispute

Tony Fratto, a spokesman for Perry Capital, at Hamilton Place Strategies LLC, declined to comment on the decision.

The government today entered its third day of trial defending its $182 billion rescue of American International Group Inc. in another Washington federal court. Maurice “Hank” Greenberg’s Starr International Co., the insurer’s biggest shareholder when the financial crisis struck, claims the assumption of 80 percent of AIG stock by the U.S. in September 2008 in exchange for an $85 billion loan amounted to an unconstitutional taking of private property.

While likely to be appealed, yesterday’s decision “effectively kicks the issue back to Congress, but we do not expect Congress will pass a GSE bill until at least 2017,” KBW analysts including Brian Gardner and Bose George wrote in a report.

Lamberth’s decision, if upheld, is “troubling,” Marcel Kahan, law professor at New York University, said in a phone interview.

‘Unilaterally Changed’

“Should the government be able to change the terms of the deal after the fact?” he asked. “They unilaterally changed the deal to make it better for the government.”

Fannie Mae and Freddie Mac shareholder-advocacy group Investors Unite “doubts that Congress ever intended for the conservatorships to lead to nationalization of” the companies “with no compensation for shareholders,” Pagliara said yesterday in an e-mailed statement. “We disagree with Judge Lamberth’s decision and we look forward to reviewing what comes out of discovery in the Fairholme trial.”

The investors challenged the arrangement in which the U.S. Treasury takes all of Fannie Mae and Freddie Mac’s quarterly profits. The practice, known as the Third Amendment, began in 2012, replacing an earlier arrangement in which the two companies paid a quarterly 10 percent dividend as a return on the U.S. bailout.

Fannie Mae and Freddie Mac, which were seized by regulators in 2008 as they neared bankruptcy, package mortgages into guaranteed bonds. They drew $187.5 billion in taxpayer funds to stay afloat before they returned to profitability. The rescue gave the U.S. the right to take stakes of about 80 percent in the companies.

‘Any Rights’

Treasury was authorized to “purchase any obligations and other securities issued by” Fannie Mae and Freddie Mac, a provision which also allowed it to “exercise any rights received in connection with such purchases,” Lamberth wrote yesterday.

The related amendment “requires Fannie Mae and Freddie Mac to pay a quarterly dividend to Treasury equal to the entire net worth of each” entity, minus a small reserve that shrinks to zero over time, Lamberth said.

The Third Amendment may “raise eyebrows, or even engender a feeling of discomfort,” Lamberth wrote in his decision. “But any sense of unease over the defendants’ conduct is not enough to overcome the plain meaning” of the text of the law under which the rescues were permitted, he said.

“Here, the plaintiffs’ true gripe is with the language of a statute that enabled FHFA and, consequently, Treasury, to take unprecedented steps to salvage the largest players in the mortgage finance industry before their looming collapse triggered a systemic panic,” Lamberth wrote, referring to the Federal Housing Finance Agency.

The case is In Re Fannie Mae/Freddie Mac Senior Preferred Stock Purchase Agreement Class Action Litigations, 13-01288, U.S. District Court, District of Columbia (Washington).

(An earlier version of this story removed a misspelling of the word “Berkowitz” from the headline.)

(Updates with comment from Fairholme in 10th paragraph.)