Appeals Court’s AIG Decision Sets Government Up For Big Win in Fannie and Freddie Cases

Fannie Mae
Getty Images/Bloomberg/Andrew Harrer

This month has been a difficult one for shareholders of Fannie Mae and Freddie Mac still hoping to shake-off government control of the mortgage giants.

Last week, a spokesman for the Treasury Department said that Secretary Steven Mnuchin supports the deal that requires Fannie and Freddie to send nearly all of their profits to the government, leaving nothing for shareholders. The Treasury spokesman also shot down the notion that Mnuchin had confirmed allegations that the Obama administration had diverted funds from Fannie and Freddie to pay for Obamacare-related subsidies, an idea spread by political operatives hoping to win conservatives over to the cause of the Fannie and Freddie shareholders.

A more serious blow came Tuesday when a federal appeals court tossed out a lower court’s ruling that the federal bailout of American International Group was unlawful. The lower court’s decision had been the basis for hope that shareholders of a bailed-out company could successfully sue the government over the terms of the bailout.

The AIG suit had been filed by Maurice R. “Hank” Greenberg in 2011. He argued that the Fed overstepped its legal authority when it demanded a 79.9% equity stake in exchange for an emergency loan that enabled the company to avert bankruptcy. In 2015, the U.S. Court of Federal Claims ruled that the government’s actions constituted an “illegal exaction” but awarded no damages because the court accepted the government’s arguments that without the loan AIG would have been forced to file for bankruptcy, leaving the shareholders with nothing.

In Tuesday’s ruling, the Appeals Court for the Federal Circuit vacated the lower courts ruling. The three-judge panel said that AIG shareholders lacked standing to sue the government because their claims “belong exclusively to AIG.” In other words, the shareholders could not bring the lawsuit because the alleged illegal actions would be harms against the company and not the shareholders directly.

Lawyers for the U.S. government will certainly bring the AIG decision to the attention of Judge Margaret Sweeney, who is overseeing a case filed in the U.S. Court of Federal Claims by Fannie and Freddie shareholder Fairholme Funds. It represents controlling law for Sweeney, which means she is obligated to apply it to her cases. Investors in Fannie and Freddie sued over the sweep of the mortgage companies’ profits in the U.S. Treasury in the Federal Claims court, which hears cases for monetary damages against the federal government.

While many of the factual and legal details of the AIG and Fannie/Freddie cases differ, the rationale for the Federal Circuit’s AIG decision is particularly damaging to the Fannie and Freddie plaintiffs in the Claims Court. Their case rests on the basic assertion that they have a right to sue as shareholders over the terms of the government’s bailout–an assertion flatly rejected by the court in Tuesday’s ruling.

The stakes in the Sweeney court have been elevated by decisions in several other federal courts to dismiss similar shareholder lawsuits. Sweeney has allowed the plaintiffs in that case to attempt to establish that her court has jurisdiction through the discovery process. That process has now dragged on for years as lawyers for the government and shareholders battle over which documents must be turned over to plaintiffs, with the government asserting that many documents are subject to privileges that allow them to be withheld.

This process could be brought to a sudden end, however, if Sweeney holds that the AIG case means the plaintiffs lack standing to sue.

Background: How Fannie and Freddie Went from Implicit Guarantees to Bailouts to Lawsuits

Fannie and Freddie provide liquidity to the housing market by buying mortgages from lenders, packaging them into securities whose principal and interest payments they guarantee. Prior to their 2008 collapse, Fannie and Freddie were widely viewed as enjoying an “implicit guarantee” from the U.S. government, enabling them to earn enormous profits because investors viewed their bonds as being safe–or nearly so–as U.S. Treasury bonds

The companies were taken over by the U.S. government in 2008 when officials feared their collapse could further destabilize the housing and financial markets. Treasury provided hundreds of billions of funding while the Federal Housing Finance Agency became their conservator.

Under their original agreement with the U.S. Treasury, both companies were supposed to pay a dividend equal to 10% of their taxpayer funding as well as a fee on the hundreds of billions more Treasury had pledged to support them. For years, however, neither company earned enough to pay the dividend, which forced them to draw even more from their bailout funds just to send the money back to Treasury as the dividend. This circular draw, as it came to be called, threatened to put the companies into a death spiral, slowly eating away at the remainder of the Treasury backstop.

In mid-2012, Treasury and the FHFA agreed to change the terms of the bailout so that Fannie and Freddie would no longer have a fixed dividend–ending the need for circular draws. Instead, each company would have a flexible dividend obligation that would rise and fall with their profits. Because the new dividend is equal to the positive net worth of each company, less a small capital cushion set to decline each year, it is known as the “net worth sweep.”

At the time the net worth sweep was implemented, Treasury Department officials noted that in addition to ending the circular draws and death spiral, the arrangement would facilitate the eventual wind down of the companies by preventing them from using profits to recapitalize as policy-makers designed a safe, more stable mortgage finance system.

Because every attempt at bipartisan mortgage finance reform legislation stalled out on Capitol Hill, neither company has been wound-down. Instead, they have remained in conservatorship and supported by taxpayer backing for more than eight years–a situation that nearly everyone involved in mortgage finance reform regards as undesirable.

Hedge funds and other big investors who have purchased shares of Fannie and Freddie, including Perry Capital LLC and the Fairholme Funds, have been attempting to undo the net worth sweep for years. These attempts have included marshaling support of civil rights groups and filing lawsuits in several federal courts. The litigation tactic, however, has largely failed. The cases have been met by dismissal in four federal district courts and a federal appeals court in March largely rejected the bid by investors to reverse one of those decisions. The case before Judge Sweeney is one of the few to have survived the government’s motion to dismiss.

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