Why Fannie Mae and Freddie Mac Investors May Want to Wait to Sell

Updated from 12:16 p.m. EDT with fresh share price data and additional detail about New York University law professor Richard Epstein in 12th paragraph.

NEW YORK (TheStreet) -- Fannie Mae (FNMA) and Freddie Mac (FMCC) investors dumped their holdings of preferred and common shares on Wednesday following a legal decision both stunning in its speed and thoroughness. But some investment pros are suggesting that it might be wiser to hold on to the shares -- for now.

On Tuesday, a U.S. District Court judge threw out four lawsuits claiming the federal government illegally forced Fannie and Freddie to pay the Treasury nearly all of its profits, leaving regular shareholders with nothing. The lawsuits, brought by shareholders including Fairholme Funds and Perry Capital, contended that the so-called "sweep" was a violation of their Fifth Amendment rights against the seizure of private property for public use without just compensation.

Watch the video below for more on the decision to dismiss shareholder lawsuits against Fannie Mae and Freddie Mac:

But the judge disagreed, saying the government had been granted broad powers by Congress, which "parted the legal seas" to deal with the financial crisis. Both Fannie and Freddie, which are government-sponsored enterprises, or GSEs, received a $188 billion bailout from the government. The mortgage giants have repaid that money and are now very profitable.

As expected, both Fannie and Freddie shares plunged on Wednesday following the decision.

"I'm licking my wounds this morning," conceded David Tawil, president of hedge fund Maglan Capital, an investor in common shares of both Fannie and Freddie.

Tawil called the decision "extremely authoritative," though he said he would hold on to his investment.

The reason? The shares have fallen so far so quickly he saw little point in selling. 

"At 50 cents a share, I'm not going to throw in the towel," he said, adding that the "option value" is pretty good. Tawil made his "50 cents a share" comment before the start of trading Wednesday, when shares were down some 60% in premarket trading.

Less than an hour before the close of trading Wednesday, Fannie Mae common shares were down 37.17% to $1.69, and Freddie Mac shares were lower by 38.26% to $1.63. Preferred shares in both entities, investments that had been favored by many hedge funds who saw them as a safer bet, were also down sharply. The Fannie Mae "S" series preferred shares were down more than 53.48% to $4.28.

Despite several lawsuits being thrown out, at least 15 others remain outstanding, including one brought by Bill Ackman's Pershing Square Capital Management, and at least one legal expert was willing to argue that investors still have a shot against the government.

Writing in Forbes, NYU Law Professor Richard Epstein called Judge Lamberth's decision a "massive injustice," and suggested that a separate but related action brought by Fairholme before U.S. Claims Court Justice Margaret Sweeney will have an outcome more favorable to shareholders. Reached by telephone, Epstein said he has no position in Fannie or Freddie securities but is a paid consultant to hedge funds with an interest in the outcome. He declined to name the hedge funds.

Tawil, who previously practiced as an attorney, was struck by the overwhelming authority the decision gives to the Federal Housing Finance Authority, which oversees Fannie and Freddie.

"You're left with an unsettling conclusion in terms of what it means to be a shareholder in any government-sponsored entity," he said. He added that the decision, if upheld, makes GSE reform easier since there is "much more limited noise that can be made from shareholders."

Fairholme spokesman Paul Frankle wrote via email, "Fairholme is certainly disappointed by yesterday's abrupt decision in the D.C. District Court. Our shareholders' investment in Fannie Mae and Freddie Mac is primarily in preferred stock, which is contractually entitled to a preferential claim upon any liquidation and priority with respect to dividends under all circumstances. Although litigation is a lengthy process, shareholder-owned Fannie Mae and Freddie Mac remain vitally important and increasingly valuable to all constituents. On behalf of hundreds of thousands of Fairholme Funds shareholders, we will vigorously pursue the enforcement of existing contractual claims and our inalienable rights of property ownership as guaranteed by the United States Constitution."

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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