Why Wall Street Hedge Funds are Trying To Force Treasury to Hand Over Fannie Mae and Freddie Mac

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Jason Reed / Reuters

Fannie Mae headquarters in northwest Washington, D.C.

When mortgage giants Fannie Mae and Freddie Mac were taken over by the Bush Administration in 2008, the nearly $200 billion bailout was the largest in history. Since that time however, and aided by the rapid recovery of the housing market, the two housing giants have once again become profitable, and as of last week they had paid the government in dividends an amount equal to to the original bailout.

Don’t call it payback though. The federal government still owns the 80% stake in the companies it bought five years ago, and the risk taxpayers took in 2008 when it bought those stakes entitles them to far more than just getting their money back. That being said, the government is surely glad that Fannie and Freddie are throwing off cash once again, especially as it’s helping dampen the budget deficit.

But not everyone is pleased about Fannie and Freddie’s newfound profitability, or at least that the money is going in Treasury coffers. According to a report today in the Financial Times, a group of private investors are preparing to put forward a proposal which would transfer the housing giants back into private hands, and ultimately end a dispute over the remaining privately-held Fannie and Freddie stock which was not eliminated during the original bailout.

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Let’s step back a bit to describe what has these investors so upset. Back in 2008, when the federal government put Fannie and Freddie into conservatorship, it provided backstop financing and in return required the companies to pay the government a ten percent dividend before any money went to private stakeholders. What the federal government did not do was fully nationalize these companies — as this would have required it to put Fannie and Freddie’s debt on its own books.

But this decision came back to bite the government when the firms’ fortunes turned around in 2012. Now that the entities were profitable, the bailed out shareholders of the universally-despised Fannie Mae and Freddie Mac would be set to benefit from the recovery of the housing market, to the tune of billions of dollars per quarter. Hoping to avoid that fate, the Treasury Department and the Fannie and Freddie’s conservator — the FHFA — decided to change the terms of the bailout and force the housing giants to send all of their profits back to the feds.

This action seems fair on its face. After all, there wouldn’t be any Fannie Mae and Freddie Mac profits had the government not bailed them out. But to others, this action is an example of changing the rules in the middle of the game. One example is Perry Capital, a hedge fund that began purchasing shares in Fannie and Freddie on the open market in 2010 under the expectation that it could share in the companies good fortune once the housing market recovered.

Over the summer, several hedge funds, including Perry Capital, filed a suit against the government in federal court seeking to overturn Treasury’s decision to take Fannie and Freddie’s profits. According to the Financial Times report, these funds are putting together a proposal in which the owners of preferred stock — which would have been receiving of dividends if the Treasury hadn’t changed the terms of the agreement — would become the new owners of Fannie and Freddie. Here’s the Financial Times: 

“The deal would see the investor group take control of Fannie and Freddie’s core businesses of guaranteeing mortgage-backed securities, in two newly-capitalized insurance companies.

Fannie and Freddie’s portfolio of previously-written guarantees and mortgage holdings would stay in government hands to be wound down, potentially at considerable profit to taxpayers. A common securitization platform, used to standardize mortgage-backed securities, would also stay in public hands.”

The outline is obviously short on details, apparently because the fine print of the investors proposal is still being worked out. But basically, the plan would be a way to put Fannie and Freddie back into private hands while resolving this dispute which could ultimately cost the Federal government hundreds of billions of dollars if the courts rule in investors favor.

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So will these investors succeed? It’s difficult to conceive of Treasury agreeing to this in the short term. One of the only things Washington seemingly can agree on these days is that Fannie and Freddie should be completely eliminated and it’s privately-held shares rendered worthless.

But Washington has also made zero progress in it’s efforts to reform the mortgage finance system. Jeff Lewis, a portfolio manager for the TIG Securitized Asset Fund which specializes in the mortgage debt markets that Fannie and Freddie undergird, argues that at least the proposal being discussed today would achieve the goal of bringing the private capital back to the mortgage market. “The one thing that you can say about the ideas that have come out of the private sector — whether they are likely or not to come to fruition – is that they’re specific and goal-oriented. What you have coming from the other people in Washington are things nobody expects to be implemented. They’re proposed for political reasons,” Lewis says.

But while such a proposal would inject private capital back into these markets, it wouldn’t satisfy Washington and the American public’ desire for justice. But this is where the Bush Administrations lack of foresight might just blow up in the government’s face. If the courts are going rule in investors’ favor, the Treasury might be better off handing over the keys to Fannie and Freddie and then working with Congress to set up additional layers of regulation and protection to ensure that 2008 never happens again.