This article by Jon Entine originally appeared on Forbes.
Five years after the government bailed out Fannie Mae and Freddie Mac by covering their combined $187.5 billion debt, taxpayers are about to be made whole, and record profits are set to stream in as far as the eye can see. But in a bizarre twist, the government may be poised to commit what some critics say could be the largest securities fraud in history.
Fannie Mae today reported an annual profit of $84 billion for $2013. Under the terms of the 2008 rescue, all of the profits will be sent to the Treasury. Fannie’s smaller rival, Freddie Mac is also set to confirm its astounding rebound next week. It’s a surprising turn of events and a windfall for the government—but potentially a looming disaster for shareholders who may lose billions for standing by the beleaguered organizations as the housing market seized during the Great Recession.
The two government-sponsored entities (GSEs), which own or guarantee a massive proportion of all home loans in the United States, were on the verge of collapse when the housing market buckled at the height of the financial crisis, prompting the government to put them into conservatorship, an alternative to liquidation that was supposed to protect both taxpayers and shareholders.
With the Treasury set to recoup its entire investment and then some, one would expect that the firms would be ready to exit government control and begin repaying their investors—more than 21,000 of them. But the near record windfall is for now mostly symbolic, as the government had re-engineered the original agreement to require the GSEs to send all their profits to the Treasury in perpetuity, meaning they can never exit government control.
And now in a disturbing turn of events, an explosive government document has emerged that suggests that the Obama Administration appears determined to liquidate most or all of their investments, as Congress stands by with proposals that would only codify the Administration’s plan—committing what an ‘odd fellows’ coalition of über-liberals, shareholder activists and hedge fund managers say could be the largest securities fraud in the history of the United States.
What’s the story behind the government’s apparent securities fraud?
The burgeoning scandal swirls around what appear to be backroom policy decisions made in 2010, just as the housing market showed signs of recovery and the ink turned from black to red on Fannie and Freddie’s books.
While the government was publicly encouraging shareholders to hang on, officials at Treasury, backed by the Administration, quietly changed policy, hatching a plan to bankrupt them, including new investors who came on board after the crash at the Government’s wooing. According to an internal memo addressed to the Treasury secretary from Jeffrey A. Goldstein, then the under secretary for domestic finance, “the administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from the GSEs in the future.”
The memo, which was produced in a lawsuit filed by Fannie and Freddie shareholders, was dated Dec. 20, 2010 and was made public at a shareholder’s rights forum held earlier this month in Washington. It puts controversial meat on the bone of a more ambiguous statement in Fannie Mae’s annual report: “[W]e are no longer managed with a strategy to maximize shareholder returns” and “every dollar of earnings that Fannie Mae and Freddie Mac generate will be used to benefit taxpayers for their investment in those firms.”
As New York Times’ business columnist Gretchen Morgensen summarized in a scathing piece last Sunday, two GSEs were not made aware of the new policy that essentially deprived them of future earnings. That appears to be in conflict with securities laws that require the disclosure of any “material” information that might affect an investor’s view of a company. In other words, federal officials were conspiring—that’s a word pregnant with implications but fair in this context—to treat shareholders more like characters in “Night of the Living Dead” than investors helping to keep a fragile agency afloat.
Did the government commit securities fraud? According to James Cummins, a leading securities lawyer who has litigated against Fannie and Freddie since 2004 on various issues, such a sharp switch in policy is “material information because it was going to tell people who might want to buy stock, ‘Hey, by the way, you’re not going to get any dividends and all of the earnings of the company are going to U.S. Treasury.’”
Who are these investors? They include hedge funds like Perry Capital and Pershing Square, but also thousands of other shareholders, including employees, pensioners, 401K funds, mutual funds and small banks, as well as individual shareholders. Among them are shareholder rights activists, including Ralph Nader.
Some of these shareholders are long term investors, who saw the stock plummet to pennies on the dollar, while others are funds that took recent but highly risky positions in hopes of benefiting from Fannie’s and Freddie’s recovery. Billions of dollars is at stake.
The litigants, including Nader, point to the government’s guarantee that it would “preserve and conserve the assets and property” of each entity. But the internal government document suggests that federal officials were doing anything but. Over the past two years they’ve siphoned off the profits of the GSEs and sent the money to the general treasury instead of repaying this obligation.
The litigants seek no damages nor do they want to short the government’s appropriate bonanza for the unanticipated market rebound.
“Shareholders are not arguing that taxpayers should not be repaid,” writes Nader in a letter sent earlier this week to Treasury Secretary Jacob Lew. “This is not at issue. Taxpayers should recoup their investment in the GSEs; but the Administration does not have to wipe out shareholders for this to happen.” Nader and other shareholders are asking the government to bide by the 2008 law, rather than what appears to be an internally hatched 2010 policy shift –another quiet form of regulatory overreach.
Will potential homeowners become collateral damage in Fannie/Freddie wrangle?
These explosive disclosures come as the House and Senate, with White House encouragement, are poised to debate bills that could wind down the GSEs over the next five years. Neither measure would likely provide common shareholders with any return on their investments.
The federal government’s backroom maneuverings and proposed Congressional bills were prompted by the public’s apparent disdain for the botched housing policy leading up to the bubble burst. During his State of the Union address in January, President Obama called for “legislation that protects taxpayers from footing the bill for a housing crisis ever again”—a view that everyone seems to share. The Administration and many members of Congress say they support unwinding the GSEs in theory, but that’s easier said then done.
Liberals chafe at the thought of bailing out moneyed interests, including GSE shareholders. “The two government-chartered mortgage companies … swallowed billions in toxic mortgage instruments as they chase profits for their private investors,” writes Paul McMorrow, a Commonwealth Magazine editor, in the Boston Globe. “The conflict between taxpayer risk and private profit … can only be solved by putting the companies down for good” — a mercy killing for many liberals.
Many equally stubborn Republicans are wary of any bill that they say could establish a new, unvetted guarantor for potential homeowners, particularly low income ones who might ‘recklessly’ borrow, creating new government liabilities. That’s always been a myth of course. After all, the implosion came from a Devil’s pact between Democrats, trying to please their base, and the financial industry that raked in billions by driving demand for “liar loans” and other abusive mortgages. No one has clean hands here.
While emotionally satisfying to the revenge crowd, allowing the government to take away all of the profits from a profitable company while giving nothing to shareholders seems unfair. It also could kill the housing dream of tens of millions of Americans, collateral damage to political wrangling.
President Obama also wants a new law that “keeps the dream of home ownership alive for future generations”—a goal that is highly unlikely unless a newly created super agency that rises Phoenix-like from the ashes of Fannie and Freddie provides the same kind of federal guarantees that critics contend contributed to their near collapse. Considering the way Congress operates, such legislation is both unlikely—and that may not be a bad thing.
After all, the private sector has done little in recent years to help debt-stretched low-to-middle income people with good credit become homeowners. As The New York Times recently wrote: “[L]ittle in the vast system that provides Americans with mortgages has returned to normal since the 2008 financial crisis, leaving a large swath of people virtually shut out of the market… a significant amount of borrowers with less-than-perfect credit scores remain largely shut out of the market.”
No one disputes Fannie and Freddie’s historic role in helping to both creating a strong middle class and contributing to one of the greatest financial debacles in modern times. And no one questions the role of Wall Street in providing critical capital to fuel the American housing dream yet helping to kill the golden goose with its own avarice.
Is there a solution-focused middle ground or are Congress and Obama determined to just kill off the GSEs as a ritual sacrifice to the gods of greed?
In practical terms, and with the mid-term elections looming, reform legislation, while popular in theory, is unlikely to get much traction. Which leaves open the door to the possibility of leaving well enough alone—letting Fannie and Freddie provide guarantees to keep the still-bruised mortgage market liquid, only this time, regulate them properly and ensure they have sufficient capital reserves.
As Matt Levine argues in Bloomberg, “[T]he status quo is great for the government. Right now, Fannie and Freddie are completely controlled by the federal government, while keeping the technical trappings of private ownership (20.1 percent private shareholders, no explicit government guarantee) and thus staying off the Treasury’s balance sheet. They can be used as a tool of housing policy (particularly, they can keep guaranteeing cheap mortgages) without being explicitly federalized.
Perhaps it’s time for a little common sense here. “This need not be an issue of choosing taxpayers over shareholders,” Nader wrote in his recent letter to Lew.
With lawsuits flying and more discovery mine bombs likely to blow in the months ahead, and court testimony from the likes of Ralph Nader, nothing good is likely to come of the government’s holding firm on its position that legitimate shareholders can have their rights taken away from them in a backroom switcheroo.
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. Follow @JonEntine on Twitter