Fannie, Freddie Plaintiffs Claim Takeover Deepened Losses

NEW YORK ( TheStreet) -- A review of the court complaint filed by private shareholders of Fannie Mae ( FNMA) and Freddie Mac ( FMCC) against the federal government shows a strong set of arguments against the legality of the companies' takeover, but also includes a weak argument that their losses since September 2008 were fed by an expansion of their mortgage investments.

Fannie and Freddie -- together known as the government-sponsored enterprises, or GSEs -- were taken under government conservatorship in September 2008. The U.S. Treasury holds $189.4 billion in senior preferred share of the GSEs in lieu of bailout assistance, while dividends on all other share classes have been suspended since September 2008.

The complaint filed on Monday by Hagens Berman Sobol Shapiro LLP of Seattle and Spector Roseman Kodroff & Willis, PC of Philadelphia on behalf of a subsidiary of Washington Federal of Seattle, the Austin Police Retirement System and a private investor, seeks $41 billion in damages, alleging the government's takeover of the GSEs violated the U.S. Constitution.

The main argument of the complaint is that the government had no legal right to take over Fannie and Freddie, since the GSEs were not insolvent and had not violated any regulatory orders. Rather than simply provide bailout funds to prop up the GSEs, as the government did for so many of the nation's largest banks, the GSEs were taken over so the government could directly use Fannie and Freddie to shore up the U.S. mortgage financing market, according to the complaint.

"These actions, while beneficial to the economic welfare of the nation, destroyed the value of Fannie Mae's and Freddie Mac's common and preferred stock and trampled the private ownership rights and property interests of the shareholders who owned these publicly traded Companies -- the very same companies that the Government had privatized years ago for its own financial benefit," according to the complaint.

Pressure to Buy Subprime Mortgage Loans

The private shareholders in the complaint make a strong case that government pressure to increase GSE investments in subprime mortgage loans helped lead to the crisis faced by the GSEs in 2008. In August 2007, James Lockhart -- then the director of the Office of Federal Housing Enterprise Oversight (OFHEO), when then regulated the GSEs -- "adjusted the Companies' ending standards so that they could purchase as much as $40 billion, combined, in new subprime loans," according to the complaint.

Later, as director of the Federal Housing Finance Agency, which now regulates Fannie and Freddie, Lockhart said at a June 2009 conference that "the affordable-housing goals set by HUD were, in retrospect, too high and caused both of them to do things they shouldn't have done, such as Fannie's getting involved in the subprime market, where it should never have gone."

Secrecy Heading Into Conservatorship

The complaint sets out the timeline leading to the GSEs' placement into conservatorship, while painting a picture of Lockhart and former Treasury Secretary Henry Paulson that's anything but pretty.

On July 10, 2008, Lockhart said in a press release that Fannie Mae and Freddie Mac were "adequately capitalized, holding capital well in excess of the OFHEO-directed requirement." Paulson on the same day made a similar statement before the House Banking Committee.

But OFHEO had in June "changed the mortgage loan loss severity formulas used in the Companies' regulatory risk-based capital stress test." The new standards were to have been applied at the end of the third quarter of 2008. Fannie Mae estimates the new standards would have raised its regulatory capital requirement by $7.3 billion.

Fannie and Freddie were placed under FHFA conservatorship on Sept. 7, 2008, after analyzing the GSEs' financial condition over the previous four weeks. But "FHFA Director Lockhart and Treasury Secretary Paulson blindsided the Companies and their shareholders," according to the complaint, because the analysis was done in secret, with no communications with GSE executives.

"The government intended to keep this plan secret until the last possible minute," according to the complaint. In a now famous quote, Paulson said to President George W. Bush on Sept. 4, 2008 that FHFA and the Treasury were "going to move quickly and take them by surprise. The first sound they'll hear is their heads hitting the floor."

According to the complaint, the consent of the GSEs' boards of directors to the conservatorship "was by no means voluntary," despite a statement to the contrary by Lockhart.

Cycle of Borrowing

The private investors make the case in the complaint that the "usurious" dividend rate on government-held senior preferred shares in Fannie and Freddie helped feed a "never-ending cycle of borrowing." The government-held preferred shares had an initial dividend rate of 10%, which was double the rate for the first five years on government-held preferred shares in bailed-out banks.

For several years, subsequent "draws" on the Treasury by the GSEs were in great part used to cover dividends on the government's preferred shares. Yes, the GSEs were borrowing from the government to pay the government.

Then in August 2012, the government stopped playing the dividend game with the GSEs, and simply required them to pay all income over to the Treasury as dividends, less a minimal $3 billion capital buffer for each GSE.

But the weakest part of the complaint is that following their placement into conservatorship, the government used Fannie and Freddie "as a vehicle to restore investor confidence in the mortgage market by providing a mechanism for other financial institutions to unload their bad mortgage debts." There are no numbers backing up this claim, in the complaint.

The shareholders in the complaint go on to quote Fannie Mae alone in saying the company "provided approximately $2.3 trillion in liquidity to the mortgage market in 2009 through 2011 through its purchases and guarantee of loans."

Fannie and Freddie have indeed greatly increased their role in the secondary mortgage market, however, loans originated from 2009 and later were underwritten under much more strict criteria than they were before the housing crisis began. These newer loans are providing a great deal of the GSEs current profitability.

Neither Hagens Berman Sobol Shapiro nor Spector Roseman Kodroff & Willis immediately responded to requests for comment.

-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.

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