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Jon Entine’s post on the government’s potential difficulties in the lawsuit brought by the holders of the common and preferred stock of Fannie Mae and Freddie Mac is on target when he described it as a “ticking time bomb.” In 2012, the Treasury revised the terms of the preferred shares it received from Fannie and Freddie in exchange for financial support. These shares originally paid 10%, but the revised preferred terms required that all the profits of the two firms would be paid to the Treasury. Given that the Treasury was on both sides of the transaction, this was bound to produce a lawsuit. But in in the end the equities in this case are not as clear as they have been made out.
The Treasury made two serious mistakes in what it did with Fannie and Freddie when they became insolvent in 2008, and these will play into the case the plaintiffs have brought.
Mistake number one was putting the two insolvent entities into conservatorship in 2008, rather than a receivership. A receivership would have wiped out all the existing shareholders at the time, which is what should happen when their investment is insolvent. A conservatorship is intended to conserve the assets for the shareholders while the firms reorganize. It is usually employed when the firms involved are not insolvent. Hank Paulson, the Treasury secretary at the time, thought that a receivership would further panic the markets, but because the Treasury immediately announced that it would use its previously granted powers to keep the firms operating, it is unlikely that this would have happened.
Mistake number two was failing to include in the firms’ filings with the SEC that the terms of the Treasury’s preferred stock in Fannie and Freddie were modified so that all of their earnings would be paid to the Treasury as dividends on the preferred stock. This was a violation of the securities laws, and was covered in detail in a New York Times article by Gretchen Morgenson (“The Untouchable Profits of Fannie Mae and Freddie Mac,” February 15, 2014) several weeks ago.
However, there are few real victims in this case. The original shareholders of Fannie and Freddie, as noted above, should have been wiped out by a receivership. The Treasury’s mistake in keeping shareholders’ rights “alive” was a windfall for this group. The shareholders that bought in after Fannie and Freddie were placed in the conservatorship were largely hedge funds, speculating on later developments. Speculation is certainly good, and is vital to price discovery, but in this case the hedge funds probably realized not only that Fannie and Freddie—because they continued to dominate the housing market—would eventually become profitable but also that they could probably push Congress to do what Entine recommends: allow these profitable companies to exit the conservatorship and resume their role as profit-making enterprises. That would have made a fortune for the hedge funds. Indeed, the Treasury’s move to extract all the profits from Fannie and Freddie was probably developed to prevent the success of this strategy. The Treasury was worried that it might succeed.
Finally, the failure to include the change in the terms of the Treasury’s preferred stock in filings with the SEC was dumb alright, but hardly the secret theft of the shareholders’ rights that Entine, Morgenson and even Ralph Nader deplored. The change in the preferred was announced by the Treasury at the time, and was widely discussed in the media. Everyone who follows the markets knew about it, especially the hedge funds that recognized and angrily protested the Treasury’s move.
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