Fannie and Freddie Investors' Hypocrisy

NEW YORK (TheStreet) -- Dear U.S. Treasury Dept., you stole my property, so I'm going to sue you, but on second thought if you give it back to me I'll throw in a bargain fix for your housing policy quandary.

That is essentially the argument being put forward by Fairholme Funds CEO Bruce Berkowitz in the letter he sent Thursday to Federal Housing Finance Authority Acting Director Ed DeMarco, in which he proposes to buy the mortgage insurance businesses of Fannie Mae  (FNMA) and Freddie Mac  (FMCC). (Treasury Secretary Jacob Lew, who may have an opinion on all this, was cc'd.)

Because Berkowitz runs a mutual fund company, which has more of a middle class flavor than the secretive hedge fund Goliaths he is working with -- names like Perry Capital, Carlyle Group's Claren Road Asset Management, and Paulson & Co. -- he is the friendly front man. The hedge funds -- whose backing for the plan was reported by the Financial Times -- aren't named in the proposal, and haven't publicly confirmed their support for it.

Many Fannie and Freddie preferred and common shareholders -- Berkowitz , at least one of the hedge funds, and other investors -- have brought various lawsuits against the Treasury.

In doing so, they have brought in possibly the most high-powered litigators in the U.S.: David Boies, a Democrat ,and Ted Olson, a Republican. The lawsuits make different arguments, though many of them take issue with a 2012 amendment to the terms under which Fannie and Freddie were put into conservatorship in 2008. While Fannie and Freddie initially were required to pay a 10% dividend to the Treasury on its $189.4 billion preferred share investment in the government sponsored entities, the amendment changed the terms of the dividend so that all of the profits would be swept into the Treasury, minus $3 billion capital cushions for each GSE.

Following their next dividend payments in December, the government will have received $185.3 billion in dividends from Fannie and Freddie. But there's no mechanism in place for either GSE to repurchase any government-held preferred shares.

I'm not a lawyer. I don't even play one on TV. But changing the rules in the middle of the game like that ain't cool. And on its face it certainly sounds like the Treasury took private property for public use without just compensation, which would be in violation of the Fifth amendment. The property taken would be the value of the preferred and common shares of Fannie and Freddie. Investors buying those securities before the 2012 amendment would have had every justification for assuming that once the government got its $189.4 billion, they'd get their share of the remaining profits.

So I think the investors have a strong case when they say the Treasury stole their property. But they undercut that case by suddenly offering to strike a deal.

Berkowitz doesn't mention the lawsuit in his letter. He told CNBC Thursday it is "about the past," while his proposal is "about the future." Whatever.

"It's going to piss off the people at Treasury," John Hempton, a hedge fund investor who predicted Fannie and Freddie's rebound as early as 2009 and says he bought Fannie and Freddie preferred shares for just a penny on the dollar. Hempton sees the Berkowitz proposal as merely the first step in what he expects will be lengthy negotiations.

"My guess is Berkowitz's lawyer told him 'once you get to the Supreme Court, anything can happen'." In other words, it might make more sense to cut a deal, even if he has a very strong legal case.

Lawsuits are settled all the time, you might say. These are all just negotiations. Maybe so, but with the future of U.S. housing finance at stake, Berkowitz's tactics could easily backfire.

-- Written by Dan Freed in New York.

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