Fannie, Freddie sued by hedge fund

Just when you thought the fallout from the housing crisis was over as buyers return to the market, hedge fund Perry Capital is suing the government over Fannie Mae and Freddie Mac dividend payments. This could be interesting, except that it’s yet another distraction for the housing agencies as they try to move forward.

The Financial Times had these details:

Perry Capital, one of the largest US hedge funds, is suing the US Treasury over the terms of large dividend payments it has been receiving from Fannie Mae and Freddie Mac, the mortgage companies taken over by the government during the depths of the housing crisis in 2008.

The hedge fund, which has invested in Fannie Mae and Freddie Mac, alleges the Treasury violated the rules associated with its control of the companies in 2012 when it began requiring them to funnel all their profits back to the US government in the form of a dividend.

This year, Fannie Mae and Freddie Mac have paid $66bn to the US Treasury as the housing market recovered and their finances improved. The Obama administration projects $238bn in revenues related to dividends from these “government-sponsored enterprises” over the next decade.

According to the Wall Street Journal, Perry Capital is angry about changes to payments that have made its long-held bet on the housing market invalid:

Investors have piled into the shares of the two firms in recent months as a rebounding housing market has resuscitated the fortunes of Fannie and Freddie, which have begun to report large profits. Fannie and Freddie, which purchase or guarantee mortgages, last month paid $66 billion to the Treasury.

Perry Capital hasn’t disclosed its stake in the preferred shares of Fannie or Freddie, though a lawyer for the firm said Sunday that the firm had made a significant investment. Investors at Perry Capital had concluded in 2010 that the firms were likely to be profitable—a position that wasn’t widely held at that time—and began buying up preferred shares that year, the lawsuit said. The firm isn’t seeking any damages in the lawsuit but would benefit if the changes made last summer were ruled invalid.

The government took over Fannie and Freddie through a legal process known as conservatorship in 2008 as housing-market losses mounted. The government agreed to inject huge sums of capital to keep the companies afloat. In return, Treasury received a new class of “senior preferred” shares that initially paid a 10% dividend, as well as warrants to acquire nearly 80% of the firms’ common stock. The government currently holds nearly $188 billion in senior preferred shares and has received nearly $132 billion in dividend payments.

Last August, the Treasury amended the stock-purchase agreement, instead requiring the firms to pay nearly all of their profits as a dividend to Treasury beginning this year. The firms don’t have to make any dividend payments when they are unprofitable. As a result, the firms can’t rebuild capital or redeem any of the senior preferred shares the government has taken.

That dividend “sweep” upended the bets of hedge funds such as Perry Capital. Sunday’s lawsuit alleges that, as Fannie and Freddie were returning to profitability last year, the government “maneuvered to ensure that Treasury would be the sole beneficiary of the companies’ improved financial position,” the filing said.

Bloomberg points out that the fate of Fannie and Freddie could be in question as the government tries to determine how they should move forward:

A bipartisan group of senators, led by Tennessee Republican Bob Corker and Virginia Democrat Mark Warner, last month introduced a bill that would dismantle the companies and replace them with a system in which the government would serve as a catastrophic reinsurer of mortgages.

Shareholders behind the government would only recoup losses after taxpayers had been made whole. Fannie Mae and Freddie Mac purchase mortgages and package them into securities on which they guarantee payments of principal and interest.

The Perry Capital lawsuit follows a shareholder claim filed in the U.S. Court of Federal Claims in Washington last month, which sought $41 billion in damages as a result of the takeover.

Perry Capital didn’t ask for monetary damages in its lawsuit. It sought a court declaration that the third amendment isn’t legal, and orders setting it aside and preventing the Treasury and the Federal Housing Finance Agency from implementing it.

This story is interesting since it seems that smart investors should reap the rewards from their foresight and patience. If Perry’s claims are right, it feels unfair for Treasury to change the rules in the middle of the investment game.

But, that’s what happens in many situations – companies are acquired or go bankrupt. People place bets on managers or dividends, which can also change. I think the outcome of this suit will be interesting going forward since it could differentiate the government from other corporations in terms of flexibility and capital management. It’ll definitely be interesting to see the outcome or if they decide to settle the case.