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Were Fannie, Freddie Negotiations Done in Good Faith?

Stocks in this article: FNMA FMCC

NEW YORK (TheStreet) -- The battle over Fannie Mae (FNMA) and Freddie Mac (FMCC) is heating up, and it would appear that Mario Ugoletti will be very busy answering questions in court for the foreseeable future.

Ugoletti served as the U.S. Treasury's director of the Office of Financial Institutions Policy and participated in the drawing up of the government's agreement to bail out Fannie and Freddie, while later serving as a special adviser to former acting Federal Housing Finance Agency Director Edward Demarco and helping draw up the subsequent agreement through which nearly all of the government sponsored enterprises' profits are being swept to the government, leaving private investors in the cold. Ugoletti now serves as a special adviser to FHFA Director Mel Watt, who assumed his post in January. 

Ugoletti's written testimony provided for a class action suit raises many questions about the government's decision to take nearly all of the profits of Fannie Mae and Freddie Mac in the form of dividends, a well as the timing of the decision.

First, some background:

Fannie Mae and Freddie Mac, the two mortgage giants that together purchase the vast majority of newly originated mortgage loans in the United States, are known as the government sponsored enterprises, or GSEs. The GSEs at the height of the credit crisis in September 2008 were facing insolvency and were therefore taken under government conservatorship.

The GSEs are regulated by the FHFA, which is directly controlling Fannie and Freddie since they remain in conservatorship.

Under their original conservatorship agreements, the GSEs were required to pay the government annual dividends of 10% on senior preferred shares issued to the U.S. Treasury for bailout assistance.

Through the fourth quarter of 2011, Fannie Mae continued to make draws from the Treasury -- that is, to borrow more -- in part to cover the 10% dividends it owed to the Treasury, until the value of the Treasury's preferred shares in Fannie increased to $117.1 billion.

Freddie made a small draw on the Treasury during the first quarter of 2012, bringing the government's preferred stake in that company up to $72.3 billion. The Treasury in 2008 was also handed warrants to acquire up to 79.9% of the GSEs common shares, "for a nominal" payment, according to testimony provided by Ugoletti after being subpoenaed as part of a class action lawsuit brought against the government by a group of private investors -- including Fairholme Funds -- holding common and junior preferred GSE shares.

While their borrowings from the Treasury were growing, the GSEs didn't issue additional senior preferred shares to the government. Instead, the value of the government's preferred stakes in Fannie and Freddie grew from their initial values of $1 billion apiece.

So the Treasury's stake in the GSEs has totaled $189.4 billion since the end of the first quarter in 2012, and both GSEs have been profitable since the second quarter of 2012. On August 17, 2012, after Fannie Mae reported second-quarter income of $5.1 billion and after Freddie Mac reported second-quarter income of $3.0 billion, The FHFA and the Treasury agreed on a "third amendment" to the original bailout agreements, through which all profits of Fannie Mae and Freddie Mac, save initial capital cushions of $3 billion for each GSE, would be swept to the Treasury.

To backtrack for a moment -- the "second amendment" to the bailout agreements called for an "initial cap" on the Treasury's investment in the GSEs of $200 billion, plus the amount of draws made through the end of 2012.

With the GSEs not only having returned to profitability but having stopped making draws on the Treasury, it was no surprise to see private investors suing the government for a seat at the table.

Fannie and Freddie both announced their second-quarter earnings this week, along with significant dividend payments to be made in March. Following the March payments, the GSEs' dividends paid to the government will total $199 billion, exceeding the value of the Treasury's investment over a period of roughly five years. That's a fat return -- far greater than the original 10% coupon on the government's senior preferred shares -- and there is no mechanism in place for either Fannie or Freddie to repurchase any of the government-held preferred shares.

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