Ackman Letter To Investors: Bullish On Fannie

Posted By: Jacob Wolinsky

Posted date: August 26, 2015

Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) (FNMA) / Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) (FMCC)

Fannie and Freddie reported another strong quarter. These results further corroborate our thesis that both entities could recapitalize and safely exit conservatorship if the Net Worth Sweep (the U.S. Government’s expropriation of each quarter’s net worth by extraordinary dividends) is eliminated. During the quarter, there were a number of positive legal developments in the shareholder litigation against the U.S. Government expropriation.

In the D.C. Court of Appeals, the plaintiffs filed a strong appeal brief against the decision last September dismissing their claims that the Net Worth Sweep violated applicable statutory restrictions. Numerous amici (friends of the court) briefs were filed in support of the plaintiffs, two of which are worth highlighting.

One came from several parties including the Independent Community Bankers of America and William Isaacs, the former FDIC Chairman, who during his career personally oversaw the conservatorship or receivership of hundreds of banks during the S&L crisis. The brief argues that Fannie and Freddie’s conservatorships were modeled word-for-word on FDIC conservatorships, and that the Net Worth Sweep

is both unprecedented and inconsistent with the goals of conservatorship as understood and implemented for over 80 years. If allowed to stand, the brief argues, the Net Worth Sweep will cause providers of capital to financial institutions to question whether the rule of law and the established hierarchy of corporate claims can be preserved in conservatorship. Banks rely on low-cost debt and preferred stock financing in order to provide low-cost loans to consumers. If the courts allow assets of a private financial institution to be expropriated during conservatorship, there will be few if any lenders willing to provide financing to financial institutions, particularly during a time of stress.

In his amicus brief, former Fannie Mae CFO Tim Howard offered an accounting-based analysis that questioned the necessity and motives behind the Net Worth Sweep. During conservatorship, the FHFA changed the GSEs accounting policies, accelerating non-cash charges, generating paper losses, and leading to a substantial majority of the Treasury’s $190 billion preferred stock investment. From 2008 to 2011, Mr. Howard shows, the GSEs’ actual credit losses were exceeded by their cash profits, while the non-cash charges that necessitated the capital injections have largely been reversed, leading the Treasury to “sweep” away almost all of the GSEs’ capital since 2012.

In the Court of Federal Claims, plaintiffs have filed redacted documents that suggest that their discovery process has uncovered evidence that contradicts the government’s defense of the Net Worth Sweep and calls into question both its necessity and true purpose. Although these documents are filed under seal, Judge Sweeney has allowed them to be used in related cases in the District Court and Court of Appeals.

Ackman Letter To Investors: Bullish On Fannie; Bearish On Herbalife


Property Rights Under Fire: Why the Government Must Compensate Fannie Mae and Freddie Mac’s Shareholders

By Tara Helfman, Yale Law School Graduate / Syracuse Law Professor

August 24, 2015

Imagine this. The owner of a small business facing a financially challenging period is forced to take out a loan from her local bank. She makes her monthly repayments on time and with interest in accordance with the loan agreement. But when the borrower’s business becomes profitable, the bank is no longer content with the original terms of the loan. Instead, it wants a larger piece of the business’s profits. So the bank decides unilaterally that it is going to undertake a “profit sweep.” Now, instead of making monthly payments at an agreed-upon rate of interest, the lender will have to give every dollar of profit she earns to the bank. She is not allowed to retain any of her profits or discharge her debt to the bank.

If this sounds outrageous to you, that’s because it is. And it is essentially what the federal government has done to Fannie Mae and Freddie Mac’s investors.

As government sponsored entities (GSEs), Fannie Mae and Freddie Mac are unique enterprises. They are federally chartered private corporations that serve the public interest by making the dream of homeownership a reality for millions of Americans.

From 1968 to 2010, these GSEs were the ultimate public-private partnerships. The companies were publicly traded and privately owned, they were capitalized by private investors, and they operated under ordinary corporate by-laws. They came to guarantee more than half the mortgages on new homes in America, all while turning a profit. Private shareholders, the federal government, and society at large had a stake in their success. But now the public-private partnership has become categorically one-sided in favor of the government.

The trouble started in 2007, when the Office of Federal Housing Enterprise Oversight pressured Fannie Mae and Freddie Mac to buy up to $40 billion of sub-prime mortgage-backed securities, mortgages that did not have a high likelihood of repayment. Notwithstanding these high-risk assets, the GSEs remained profitable. But the following year, the national market for sub-prime mortgages reached a point of crisis as financial institutions that the government deemed “too big to fail” found themselves on the verge of collapse. The federal government stepped in once again with a sophisticated maneuver.

Congress effectively made the GSEs an offer they could not refuse. In exchange for $1 billion of interest-bearing preferred stock, the government would advance each GSE up to $100 billion – totaling $187 billion. To seal the deal, Congress passed a law that put the companies in conservatorship under their new regulator, the Federal Housing and Finance Agency.

But in 2012, with the GSEs growing increasingly profitable, Treasury unilaterally rewrote the terms of the agreement, amending the original agreement in such a way as to turn Fannie Mae and Freddie Mac into the government’s own ATM. Under the new terms, also known as the third amendment, the federal government would keep its preferred shares in the companies, but instead of collecting interest, the U.S. Treasury would help itself to “a quarterly sweep of every dollar of profit that each firm earn[ed] going forward.”

This may be a boon for the federal government, but it is highway robbery for the companies’ investors and continues to keep taxpayers hostage to another bailout. As of this April, Fannie Mae and Freddie Mac have paid over $220 billion to the Treasury, $40 billion more than the companies had borrowed in the first place. Other holders of the companies’ preferred shares – shareholders that range from institutional investors to insurance companies to pension funds – have not seen a penny.

Some of these shareholders are now challenging the government’s actions in the courts. One of their most compelling claims is a constitutional no-brainer: the government cannot confiscate private property without paying for it. This safeguard is so essential to liberty that it is enshrined in the Fifth Amendment of the Bill of Rights, which provides that “private property shall [not] be taken for public use without just compensation.”

The Treasury has been benefiting from the profit sweep to the tune of billions of dollars. But the cost of that bonanza is being borne by shareholders, whose legitimate expectations were pulled out from under them, and by individuals whose pensions are reliant on investments in Fannie Mae and Freddie Mac.

If the courts deny the plaintiffs compensation for the property the government has taken, they would set a dangerous and self-defeating precedent. They would deter prospective investors from taking a risk on GSEs, making it impossible for the government to marshal the energy and ingenuity of the private sector to serve the public interest. Moreover, by allowing the government to keep its thumb on the scales in its dealings with private investors, the courts would hollow out a key constitutional safeguard of private property rights.

The Department of Treasury could resolve this problem in the same way it created it: by fiat. Revoking the profit sweep would allow Fannie and Freddie to proceed under the original terms of their agreements with the government. The time for having government-backed housing finance should be over, but before we can move to that end, the Treasury must follow the rule of law.

Moreover, reverting to the initial terms of the agreement would take the taxpayers off the hook for the extraordinary risk created by the profit sweep. As long as the government is helping itself to 100% of Fannie and Freddie’s profits, it is impossible for the companies to build a surplus sufficient to weather any future financial storms. And when hard times hit, as they always do, the taxpayers will bear the burden.

Denying Fannie Mae and Freddie Mac’s preferred shareholders compensation for the government’s profit sweep would be a gross injustice in the short term and a profound blow to liberty in the long term. But the political fix is quite simple, and requires nothing more than a commitment to free-market principles and the rule of law. Until that happens, time – and the courts – will tell what the fate of property rights will be.

Good News For Fannie And Freddie Shareholders?

“We have been allowed to take discovery of the government over its objection,” says Charles Cooper, the lead attorney representing Fairholme Funds in Fairholme Funds Inc. et al. v. United States.

The plaintiffs in one of the lawsuits involving Fannie Mae and Freddie Mac received some good news in July – and people involved in related lawsuits might benefit, as well.

In Fairholme Funds Inc. et al. v. United States, the plaintiffs, which include the mutual fund and several insurance companies, argue that the Federal Housing Finance Administration (FHFA) took the plaintiffs’ property without just compensation under the Fifth Amendment of the U.S. Constitution. The property was stock in the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which have been under conservatorship since 2008.

The case challenges the “net worth sweep,” which was an action the U.S. Treasury took in August 2012. The sweep was the result of a “third amendment” to the bailout agreement between the companies and the Treasury (i.e., this was a change in conservatorship rules as opposed to a change to the Third Amendment of the U.S. Constitution). As a result of the change, the U.S. Treasury took the profits the GSEs generated to repay the 2008 bailout of $188 billion. The case is related to other cases with similar claims.

The Fairholme case was filed on July 9, 2013, in the U.S. Court of Federal Claims. “When you are suing the government and you go for damages, you go to the Court of Federal Claims,” says Charles Cooper, the lead attorney for Fairholme. “We are seeking injunctive relief.”

Fairholme also filed a lawsuit in the U.S. District Court for the District of Columbia, and that case is on appeal in the U.S. District Court of Appeals. In July, Judge Margaret Sweeney, presiding over the case in the Court of Federal Claims, granted the motion that Fairholme may file the materials found during discovery in the Court of Federal Claims case and use it in the related District Court case. This means the lawyers can read the more than 10,000 documents that the government claims is protected information and that may offer insight into whether the government broke the law when it changed the rules.

“We have been allowed to take discovery of the government over its objection,” says Cooper, who is with Cooper & Kirk in Washington, D.C. “We asked Judge Sweeney to permit us to share some of the documents that we believe are important and relevant, and she has granted it.”

The documents are under seal and not available to the public. “It’s not even available to my clients,” Cooper says. “It is only available to the lawyers representing the client, to me and my colleagues in my firm.”

The original complaint explained that in 2008, when the FHFA placed the GSEs into conservatorship, the U.S. Treasury exercised its temporary authority to provide them with capital. Meanwhile, public trading of Fannie and Freddie’s stock continued. The U.S. Treasury entered into purchase agreements in which the Treasury invested in a newly created class of securities: Preferred Stock or Government Stock. The stock helped the GSEs remedy the book losses that had resulted from the financial crisis, and the Treasury earned a 10% dividend.

By 2012, the complaint noted, Fannie and Freddie had regained profitability and no longer had to draw on capital from the Treasury. The Treasury was earning dividends.

“But Treasury was not content,” Cooper wrote in the complaint. “It wanted to cut out the preferred shareholders entirely, and it wanted all the profits.” The Treasury implemented changes, including the Third Amendment “sweep” that changed the 10% dividend to a dividend of 100% of all future profits of the two companies, in perpetuity. The government did not pay the holders of preferred stock any compensation.

In fact, wrote Cooper, the government could have ended the conservatorship because it had been successful. Instead, he says, “the government nationalized the companies and expropriated their entire net worth and all future net profits.” Holders of the companies’ stock expected a return to normal business and that they could redeem stock the way they might with any publicly traded company.

Other shareholders have filed separate lawsuits. Some of these are Cacciapalle, et al. v. United States; Fisher v. United States; Reid v. United States; Washington Federal, et al. v. United States; Rafter v. United States; and Arrowood Indemnity Company, et al. v. United States.

The discovery decision will help attorneys in other cases, too. “Judge Sweeney’s order allows attorneys in the Fisher and Reid cases access to the government’s document production and the right to attend and receive transcripts of any depositions,” explains Noah M. Schubert, an attorney with Schubert Jonckheer & Kolbe, which represents Fisher and Reid in the two shareholder derivative cases against Fannie and Freddie. “The amended protective order in Fairholme now includes our cases. We are in the process of coordinating with the government to begin receiving the document production.”

Other suits include shareholders in Iowa who filed a case in May. The New York Times filed a motion to release information so that media outlets can report on it.

According to the complaint, Fairholme Funds is a mutual fund with more than 171,000 shareholders who have an average of $43,000 in their accounts. The fund performed well in the first quarter, according to its Portfolio Manager’s Report for the first half. If someone had invested $10,000 in Fairholme at the fund’s inception in December 1999, the investment would have been worth $53,107 on June 30. Meanwhile, the S&P total return for that time period would have totaled $18,952. The fund’s biggest winners, the report indicated, were AIG, at 29.6% of the portfolio, and Bank of America at 20.6%.

Cooper says the next step is to collect the information and prepare documents for filing in the U.S. Court of Appeals. There is no timeline on that, but Cooper hopes the government will mediate. “We reached our hand out to the government,” Cooper says. “We would like to do that, [but] so far to no avail. I still hold out some hope the government may agree to resolve this dispute amicably.”

Another case is Perry Capital v. Lew. In that case, Investors Unite, a coalition of investors, filed an amicus curiae, or friend of the court brief, in July. Michael H. Krimminger, partner with Cleary Gottlieb Steen & Hamilton, who is retained by Investors Unite, says the point of the brief is that the Third Amendment sweep violates the Housing and Economic Recovery Act (HERA) of 2008. Specifically, the sweep violates the requirement that a conservatorship be conducted with the goal of restoring the companies to a “sound and solvent condition.”

“The model for the HERA statute was clearly the Federal Deposit Insurance Act,” says Krimminger, who previously held executive positions with the Federal Deposit Insurance Corp. “When you are interpreting HERA you should look back, and you would see that FHFA conservatorship is completely at odds and completely contrary to how the FDIC would do conservatorship.”

Krimminger does not predict how the Perry case or the related cases will conclude, but he hopes the FHFA will set aside a trust to pay damages if the government is found liable. “That’s interesting from a public policy perspective, too,” he says. “Right now with the way the Third Amendment works, they are stripping currently earned value, also decreasing bit by bit the cushion they had held, so it will be zero by 2018.”

Some onlookers say the lawsuits go beyond taking money from stockholders. In the Perry Capital case, The National Black Chamber of Commerce filed an amicus brief in July. The brief noted that the case involves the federal government’s attempt to liquidate and nationalize Fannie Mae and Freddie Mac. That will negatively impact African Americans who are trying to buy homes. “Under the FHFA’s conservatorship, African Americans have been disproportionately unable to get conventional mortgages, and the ‘homeownership gap’ between whites and blacks has exacerbated,” wrote Pierre H. Bergeron, an attorney with Squire Patton Boggs.

“Fannie Mae and Freddie Mac are the keys to middle-class homeownership,” says Harry C. Alford, president and CEO of the National Black Chamber of Commerce. “What we want is a return to the days of stewardship, of government-sponsored enterprises. That’s important to our constituents. Without those mortgage tools, it’s going to be difficult to get loans.”

Alford is not optimistic about an amicable outcome. “My experience with this government is they don’t mediate,” he says. “It’s a fight. We’ve won before.”