United States: Treasury Seizing Profits From Fannie Mae And Freddie Mac In Violation Of The Law?

Here's a good story: A business runs into a serious crisis-a fire, or flood, whatever, the detail is less important than the magnitude of the problem, which is an existential threat to the continuation of the business. Along come some guys with lots of cash willing to become "silent partners" in the business. They offer all the cash the business needs to get back on its feet in the form of both a loan and stock purchase, but in return they want a guaranteed 10% "interest" plus a pro rata share of the profits of the business. The company already has both common and preferred classes of stock and agrees with the "money-guys" that their 10% guaranteed return will be treated as "special preferred" stock. The balance of their investment will be common stock equal to 80% of that entire class of shares.

With this new capital, the business repairs the damage done by the disaster, purchases new equipment, improves its operations, and not only continues in business, but actually turns the corner and starts to make a profit. It pays the 10% premium due on the "special preferred" stock and tells the CFO to calculate the dividend payments due to the holders of preferred and common stock.

Sounds like an American success story, right? Risk capital reaping its just reward! Well, not so fast.

One day the "money guys" show up at company headquarters and tell the CEO: "Nice business you got here. It would be too bad if something were to happen like that fire a few years ago. So, tell you what we're going to do, instead of us getting our 10% plus our 80%, we're going to get 100% of the profits, not just this year but every year from now on. And, by the way, don't even think about paying us back our investment, because you won't have any money left to do that."

Former U.S. Solicitor General, Theodore Olson, writing for the Wall Street Journal, provided an excellent summary of what the government is up to: "The federal government currently is seizing the substantial profits of the government-chartered mortgage firms, Fannie Mae and Freddie Mac, taking for itself the property and potential gains of private investors the government induced to help prop up these companies."

Investors are fighting back with lawsuits seeking money damages and injunctions to stop the Treasury from continuing to sweep Fannie's and Freddie's earnings into the federal coffers. Institutional investors, including mutual funds, insurance companies and other owners of preferred securities have sued in federal court, claiming that the Treasury and the Federal Housing Finance Agency have exceeded their statutory authority, breached the contractual rights of the preferred shareholders, and breached the fiduciary duty owed to investors arising out of the conservatorship into which the mortgage GSEs were placed. Read a copy of the complaint filed in one such lawsuit here.

Whether or not these lawsuits are meritorious, the consequences of the Treasury's actions on financial institutions promise to be profoundly bad and far reaching. Banks have long been encouraged to hold preferred stock in Fannie and Freddie as part of their regulatory capital. What will be the impact on those banks if these investments are now worthless? How will the government's actions impact Fannie and Freddie's ability to return to profitability? And what does this conduct say about the Administration's adherence to the rule of law?

Legislation has been introduced, under the guise of protecting taxpayers, that would retroactively legalize the government's actions. If the Treasury and FHFA were not acting beyond legal bounds, why is such legislation even needed? And why are supposedly conservative Republicans supporting it? These questions demand answers.

For further information visit Waller's Banking Law Blog

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