Fannie and Freddie Plaintiffs Eye FDIC Share Sales

NEW YORK ( TheStreet) -- Few noticed when the Federal Deposit Insurance Corp. (FDIC) sold some 31 million preferred shares of Fannie Mae ( FNMA) and Freddie Mac ( FMCC) on three separate dates in spring 2011, but as a legal battle heats up between the U.S. government and private shareholders of the Government Sponsored Enterprises, those transactions are taking on new significance.

The question boils down to this: Did the FDIC trade on inside information from the Treasury Department?

The FDIC and the Treasury Department say it did not, but don't expect their answers (which I'll go into more deeply in a moment) to satisfy private plaintiffs.

"We have only recently come to understand ourselves that the FDIC in 2011 sold a very large stake of stock in the GSEs," Chuck Cooper, an attorney representing Fairholme Funds in its case against the U.S. government, told me Wednesday. Cooper said the sales, in light of circumstances surrounding them, raise "gravely important issues."

Those circumstances include a Dec. 20, 2010 internal U.S. Treasury Department memo unearthed recently as part of the litigation, stating "the [Obama] administration's commitment to ensure existing common equity holders will not have access to any positive earnings from the G.S.E.'s in the future." (The New York Times' Gretchen Morgenson reported on the memo Feb. 15.)

The public, including the GSE shareholders referred to in the memo, were not privy to this commitment, but what about the FDIC? What did its officials know when they sold the vast majority of the shares the regulator acquired from failing banks it seized in the wake of the 2008 mortgage crisis?  (The FDIC says it still owns about 130,000 GSE shares, of which 46,000 are common.)

Any investor aware of the full extent of the Administration's hostility to GSE shareholders would have thought much more carefully about holding onto any preferred or common shares. That hostility may have been implicit in the fact that the Administration rarely if ever mentioned shareholders in its public statements about the GSEs after the crisis, an argument made frequently by consumer activist and GSE shareholder Ralph Nader. Still, it was never made as plain in public as it was in that internal memo. An investor aware of the memo would have thought much more carefully about holding onto any preferred or common shares.

Hedge fund manager Michael Kao of Akanthos Capital Management says it was widely known in the marketplace the FDIC was the seller when the large blocks of GSE preferred shares that came up for bid in 2011. (The exact dates of the 2011 sales were March 22, April 13 and May 18, according to the FDIC.)

"I remember distinctly asking myself during those auctions, 'hmmm I wonder what the FDIC knows that I don't.'" Kao recounted to me in an email exchange.

Kao, a long-time Fannie and Freddie shareholder, continues to hold stakes in both GSEs.

An investor aware of that memo would also have been less shocked by the highly controversial third amendment to the GSE conservatorship announced Aug. 17, 2012. The amendment changed the terms of Fannie and Freddie's debt to the government. Instead of owing the Treasury an annual 10% dividend, the GSEs suddenly owed the Treasury all of their profits for an indefinite period, aside from minimal capital buffers. That amendment -- also known as the "net worth sweep" -- is at the crux of many of the roughly 20 lawsuits brought against the government by GSE shareholders. The lawsuits taking issue with the sweep contend it violates the fifth amendment of the U.S. constitution's prohibition of the taking of private property for public use without just compensation.

Once the net worth sweep was announced, GSE preferred shares dropped sharply in value. For example, the benchmark Fannie Mae "S" series preferred shares, which closed at $2.35 on Aug. 16, 2012, closed the following day at $1.05 and at $0.86 the day after that. They would remain below a dollar until Oct. 10 and below $2 until Feb. 22, 2013.

As of this Thursday, they are at $12.08, driven higher by a Freddie Mac earnings report, as well as a judge's decision late Wednesday that plaintiffs' attorneys will be allowed to question current and former government officials for the first time.

Given where the shares trade now, it is clear the FDIC would have done far better to have hung onto its shares. However, the shares have rallied largely because of the lawsuits and also because of an increasing consensus that returning the GSEs to something like their pre-crisis status might not be such a bad idea. The FDIC was unlikely to have made such a gamble at the time.

FDIC spokesman David Barr told me in an email exchange that the FDIC was not informed by the Treasury of the "administration's commitment" as described in the memo.

"Generally speaking, it is the FDIC's practice to dispose of inherited assets as quickly as possible while maximizing proceeds to the receivership(s). We also identify opportunities to maximize economies of scale," Barr wrote.

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