For the past couple of years, a group of America's smartest investors have been betting big on Fannie Mae and Freddie Mac. The adventurous crew include John Paulson's Paulson & Co., Bruce Berkowitz of Fairholme Capital, and Richard Perry of Perry Capital. Their strategy is to exploit the remarkable revival of the two bailed-out, formerly loss-stricken mortgage insurers to prod Congress into privatizing them. If that happens, their long shot will produce many of billions of dollars in gains from IPOs that would rival the best of tech debuts for enriching investors.
Those hedge funds are lobbying Congress hard to make Fannie and Freddie independent, profit-making companies resembling the old Fannnie and Freddie. But in recent weeks, the chances that will happen have faded dramatically. New legislation co-sponsored by Senators Bob Corker (R-Tenn.) and Mark Warner (D-Va.) would slowly wind down Fannie and Freddie, replacing them with a federal agency that would provide reinsurance for mortgage-backed securities in case of a financial crisis, but leave private investors to shoulder most of the risk.
Faced with a frosty reception from lawmakers, the hedge funds are now deploying a backup plan. On Sunday, Perry Capital announced a lawsuit against the U.S. Treasury, which bailed out Fannie and Freddie, and the Federal Housing Finance Agency. Perry Capital is not seeking financial damages. Rather, it's claiming that the Treasury acted illegally in stripping capital from Fannie and Freddie that should go to folks and funds that hold their preferred and common stock.
The suit challenges an extraordinary change in the original bailout agreement that the Treasury imposed last summer. In 2008, the Treasury recapitalized the two GSEs with a cash infusion in exchange for preferred stock holdings that now total $189 billion. Under the original terms, Fannie and Freddie each paid a 10% dividend to the Treasury on the preferred. But on August 17, 2012, the Treasury canceled that 10% dividend and required that Fannie and Freddie pay all of their future earnings, forever, to the Treasury.
Why did the Treasury enact the so-called Third Amendment that so radically altered the preferred-stock agreement? By mid-2012, Fannie and Freddie were beginning to generate what would become gigantic earnings as the housing market rebounded. If the original agreement remained in place, the GSEs would build far more than $100 billion in retained earnings, and hence fresh capital, in 2013 alone. That would exert pressure for Congress to allow Fannie and Freddie to pay back the government in full, and reemerge as private players. Timothy Geithner was strongly opposed to the rebirth of the old Fannie and Freddie. The "sweep clause" that grabbed the entire windfall in profits was specifically designed to ensure that Fannie and Freddie remained wards of the state that would eventually be liquidated.
On June 3o, Fannie paid the Treasury a $66.3 cash dividend from its earnings for the first quarter -- more than any company had ever paid in an entire year. The Perry lawsuit charges that the extra profits flowing to the Treasury largely belong to private investors. "The Third Amendment ... destroys value in all the Companies' privately held securities and illegally begins to liquidate the Companies," states the complaint. "This blatant overreach by the federal government to seize all the Companies' profits at the expense of ... private investors is unlawful and must be stopped."
The complaint projects that given their earnings power, Fannie and Freddie, if allowed to keep those profits, could repay the entire $189 billion in preferred by next year, including the future interest. Indeed, the pair promise to remain highly profitable for years to come. "They will keep rolling with big profits," says Brian Harris, a fixed-income analyst with Moody's. "They now guarantee around 80% of all new mortgages, and the quality of the loans they've backed since 2010 is excellent."
A major obstacle for Perry and its allies is that the original bailout terms provided no mechanism for Fannie and Freddie to ever repay the government, no matter how much money they earn. The Perry suit alleges that the Treasury and FHFA are violating their obligation to conserve Fannie and Freddie's assets and run them in a financially sound manner, and hence penalizes private investors. It also states that they lack the legal authority to wind down the GSEs.
In effect, the suit challenges the very purpose of the bailout and the government's intentions ever since, which is to ensure that Fannie and Freddie never, ever reemerge as private companies. The chances that would happen were always remote, but the markets aren't saying it's impossible. Both the preferred and common shares are selling at many times their levels a year ago, giving the hedge funds gains that will multiply once again in the unlikely event they win this suit, unlikely indeed.
FORTUNE -- In the Oct. 30, 1989, issue, Fortune profiled 12 rising stars in the world of investing under a provocative headline: "Are These the New Warren Buffetts?" There can be only one Oracle of Omaha, of course. But looking back, our search for investors with a Buffett-like skill for compounding money proved to be highly successful. "Odds are that at least a few will go on to investing fame MOREScott Cendrowski, writer - Feb 15, 2012 5:00 AM ET
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