treasury

What's behind Perry Capital's Fannie and Freddie gambit?

July 8, 2013: 1:19 PM ET

Congress isn't likely to privatize the mortgage finance giants, so some hedge funds are turning to Plan B: suing the government.

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.

MORE: Bruce Berkowitz's big bailout bet on Fannie and Freddie

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.

MORE: The rebirth of Fannie and Freddie

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.

  • 10-year Treasuries: Buy today, cry tomorrow

    If the CBO is right, you would be better off hiding your money under your mattress for the next two or three years than using it to buy a 10-year Treasury note today.

    - Feb 15, 2013 10:46 AM ET
  • Fed official: Our bond-buying is potentially toxic

    If interest rates were to suddenly rise to their historic levels, the Federal Reserve's investment portfolio could be doomed.

    By Rob Curran

    FORTUNE -- Federal Reserve critics have long warned that quantitative easing may result in a dangerously bloated balance sheet at the central bank, but it's never been clear why the Fed's internal finances should matter to you and me.

    Now Dallas Federal Reserve President Richard Fisher is arguing that the MORE

    Jan 18, 2013 8:25 AM ET
  • How the platinum coin could work (or backfire)

    The unusual move of minting a large platinum coin might shock politicians into cleaning up the fiscal mess. But the rest of the world may see it as inflationary.

    By Mohamed El-Erian

    FORTUNE -- In just a few weeks, the "platinum coin" option has gone from a wacky idea to becoming the subject of serious discussion among academics, market participants and, yes, some politicians. In itself, this evolution says a lot MORE

    Jan 11, 2013 9:07 AM ET
  • Did Treasury leave money on the table with AIG?

    The U.S. government is sill unloading its huge stake in AIG. But why must it offer discounts?

    FORTUNE -- On the surface, it seemed like highway robbery: The U.S. Treasury sold off almost $6 billion worth of AIG shares yesterday at $30.50 each -- a whopping 7% discount to AIG's stock price before the weekend.

    By day's end, the stock had climbed right back up. After shares dipped to the offering price Monday morning, they traded MORE

    - May 8, 2012 12:05 PM ET
    Posted in: , ,
  • AIG bailout: $42 billion to go

    Clarification: 3/8 8:40 AM.

    The Treasury Department is selling $6 billion worth of its AIG stock at a profit. But it's still not clear taxpayers will come out ahead on the insurer's bailout.

    FORTUNE -- The good news: The government is about to get an another $14.5 billion of the money it poured into AIG (AIG) at the height of the financial crisis. The bad news: Uncle Sam is still owed $36 MORE

    - Mar 7, 2012 6:19 PM ET
    Posted in: , ,
  • The Fed's scary doomsday drill

    Hoping Aug. 2 will come and go uneventfully? Read Wednesday's comments from Philadelphia Fed President Charles Plosser and weep.

    Plosser (right) says the Federal Reserve is gearing up for a possible U.S. default should the loons in Congress fail to raise the debt ceiling. He stresses in an interview with Reuters that he isn't predicting this baleful outcome, but he doesn't underplay how quickly a default might spin out of control.

    The MORE

    - Jul 20, 2011 5:05 PM ET
    Posted in: , , ,
  • Life after a debt downgrade: Clawing back to AAA

    We know how the U.S. can lose its top-notch credit rating. The question is how do we restore it? The answer isn't so simple.

    By Tory Newmyer, writer

    FORTUNE -- It would be relatively easy for the U.S. to lose its prized AAA credit rating. All our policymakers need to do between now and Aug. 2 -- when the federal government reaches the end of its borrowing authority -- is nothing. At MORE

    Jul 18, 2011 10:30 AM ET
  • Foreigners still buying U.S. bonds

    Foreigners continued to buy American in May.

    Overseas investors bought $45 billion worth of U.S. stocks and bonds, the government said Monday in its monthly Treasury International Capital report. That's up from $31 billion in April and above the $40 billion net purchase forecast by economists.

    Among the big purchasers, as usual, were China, whose official stock of U.S. Treasury holdings rose by $7 billion to a globe-topping $1.16 trillion, and Japan, MORE

    - Jul 18, 2011 9:36 AM ET
    Posted in: , , ,
  • AIG's long road to stock buybacks

    Who is most eager to put the AIG bailout in the rearview mirror?

    The government would certainly like to sell off its holdings in the giant insurer sooner rather than later. Witness its decision to sell a big chunk of AIG (AIG) shares this spring even with the stock down sharply from its level at the end of 2010.

    But AIG chief Bob Benmosche makes clear in the video below that he MORE

    - Jun 22, 2011 4:21 PM ET
    Posted in: , , ,
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.