This article by Jon Entine originally appeared on AEIdeas.
In a flurry of developments last week, Fannie Mae and Freddie Mac, on life support three years ago, are now officially cash cows for the US Treasury. But they are more than that: legal experts believe they may be ticking time bombs for the Federal government, which faces an explosive court challenge to its backroom handling of the bailouts.
First the good news, at least for taxpayers. On Friday, Freddie, the smaller of the two Government Sponsored Enterprises (GSEs), announced it had earned $8.6 billion in last year’s fourth quarter. Combined with the $6.5 billion reaped over the same period by Freddie, the two firms are poised to return all of the $187.5 billion paid to them during the 2008 government rescue, plus a tip of $15 billion, with more money headed Treasury’s way as far as the eye can see.
It’s a startling turn of events. But the windfall doesn’t mean much for the GSE’s 21,000 shareholders, who may see none of the profits. At least that’s the government’s contention. The courts may see this differently.
Putting a damper on the government’s celebration, last week a federal judge granted a motion by Freddie and Fannie shareholders allowing them to proceed with discovery in their suit against the government. Who are these investors and what is their beef? They are hedge funds but also thousands of employees, pensioners, 401K funds, mutual funds and small banks, as well as shareholder rights activists, including, surprisingly, Ralph Nader.
As happened so often during the financial meltdown, the government cherry-picked winners and losers among debt holders that it selectively chose to prop up. It was often arbitrary and political, but now it turns out it also may have been illegal. Just as the housing market began turning around in 2010, officials at Treasury, backed by the administration, hatched a plan to turn common and preferred shareholders into zombie investors, including those who had come on board after the crash at the government’s wooing.
Instead of using profits to pay off the GSE’s debt, the government secretly switched gears, deciding to send all earnings directly to the Treasury, planning to maintain Freddie and Fannie as shells until the government chose to put them out of their misery. But then the unexpected turnaround happened, complicating matters.
Investors contend they assumed substantial risk—few people thought Freddie and Fannie would rebound, let alone become investment stars—and so they have a right to share in the GSE’s revival. The litigants point to the government’s bailout guarantee that it would “preserve and conserve the assets and property” of each entity.
“Taxpayers should recoup their investment in the GSEs,” wrote Nader in a later sent last month to Treasury Secretary Jacob Lew, “but the Administration does not have to wipe out shareholders for this to happen.”
In the months since the suit was filed, the government had cockily assumed it would brush off the legal challenge by maintaining that the GSEs are still in a government-run conservatorship, insulating them from legal challenge.
But the ground shifted when word of apparent backroom shenanigans emerged over the past month. According to an internal 2010 memo unearthed by the plaintiffs, a top Treasury official privately encouraged the government to abandon its commitment to shareholders, saying “existing common equity holders will not have access to any positive earnings from the GSEs in the future.”
The memo has rocked the case. As New York Times’ business columnist Gretchen Morgensen noted in a scathing exposé two weeks ago, Treasury officials apparently “just forgot” to tell shareholders that they had changed the investment rules in the middle of the game. This failure to disclose appears to conflict with securities laws that require notifying investors of any “material” information. In other words, federal officials appear to have conspired—a word pregnant with implications but not unfair in this context—to treat shareholders more like characters in “Night of the Living Dead” than investors who had helped keep the fragile home market from total collapse.
Compounding the problem, when the bailout was hastily cribbed together during the height of the crisis, there was almost no oversight by the courts or Congress. That loosey-goosey management style apparently continued at Treasury. Now, the failure by the administration and government officials to cleanly and openly deal with Fannie and Freddie shareholders is coming back to haunt them.
A lot is at stake here. President Obama has said he wants a new law winding down Freddie and Fannie yet preserving their critical role in the marketplace for aspiring homeowners—“keep[ing] the dream of home ownership alive for future generations.” That goal seems increasingly unlikely.
With the mid-term elections looming, reform legislation, while popular in theory, is unlikely to get traction. Which leaves open the door to the possibility of leaving well enough alone—letting Fannie and Freddie make oodles of money for taxpayers while providing guarantees to keep the still-bruised mortgage market liquid, only this time, regulate them properly and ensure they have sufficient capital reserves.
The judge’s decision to allow discovery does not bode well for the rest of the government’s case. Whenever it’s sued, particularly in challenges to its decision-making during a crisis—and this was the Whopper of modern-day financial crises—the courts traditionally act deferentially. Not this time. And plaintiffs are convinced that the leaked 2010 memo is just an ankle glimpse of what could be a motherlode of questionable internal policy decisions hiding behind government skirts.
With lawsuits flying and more discovery mine bombs likely to explode in the months ahead, and with court testimony from the likes of Ralph Nader planned, nothing good is likely to come of the government holding firm on its position that it’s okay to decide behind closed doors to strip legitimate shareholders of their legal rights.
Jon Entine is a senior fellow at the Center for Health & Risk Communication and STATS (Statistical Assessment Service) at George Mason University and a visiting fellow at the American Enterprise Institute.