Unless one follows the Fannie Mae/Freddie Mac conservatorship drama on a regular basis, it is easy to get lost in the legal weeds. MND has dipped in and out periodically, and it is time for another update.

To briefly reprise. When the two government sponsored enterprises (GSEs) were placed in government conservatorship in 2008 each were given access to multi-billion-dollar lines of credit from the U.S. Treasury. Under the terms of their Senior Preferred Stock Agreement (SPSA), Treasury would be given dollar-for-dollar shares of preferred stock and would receive a fixed quarterly dividend.

Fast forward to 2012.  During their four years in conservatorship the GSEs had drawn billions of dollars from the Treasury, (to date Fannie Mae has drawn $116.1 billion and Freddie Mac $71.3 billion) but had recovered substantially from their earlier financial condition. At this point they were still making quarterly draws, but increasingly these were mostly necessary to make their dividend payments.

In late 2012, FHFA acting director Edward J. DeMarco and Treasury Secretary Tim Geithner announced they were amending the SPSA, replacing the dividend with a "net worth sweep" that would take all of the companies' net profits each quarter less a steadily decreasing buffer of capital.  The buffer reaches zero at the end of this year leaving the GSEs with no capital reserves.

The change was given two rather contradictory rationales. First, that under the existing agreement the GSEs constantly borrowing from Peter to pay Peter, and second, the change would help preserve the remaining Treasury balance available to the GSEs in the event they needed them.  

Excluding the first quarter 2017 dividend payment, Fannie Mae has paid Treasury $159.9 billion in dividends and Freddie Mac $105.9 billion, none of which has reduced the amount of their Treasury debt. Neither has required a draw since the fourth quarter of 2012.  

While this was going on, both Fannie and Freddie continued to be publicly held corporations with thousands of stockholders.  Some are hedge funds that grabbed huge blocks of stock post conservatorship at fire sale prices. Others are individuals, mutual funds, and retirement plans that bought what they thought were shares in solid, dividend producing companies at prices well over $50 per share.

Shareholders filed suit against the government, arguing that the collection of profits was an improper taking of private property without compensation.  The original Treasury Department assertions that the amendments to the SPPA were necessary to protect taxpayers for likely future losses in their operation were reiterated in court by the Justice Department (DOJ) which said, "the bailout terms were modified because the companies were in a death spiral." 

While there are a number of suits in progress in various courts, many of them are now appeals of earlier rulings in favor of the government, the one most germane to this update was filed in 2013 by Bruce R. Berkowitz, President of Fairholme Funds.

Gretchen Morgenson writing for the New York Times (NYT), picks up the GSE story line. Her article published this week is an update of one she wrote in April 2016.

Morgenson says the government demanded an unusual amount of secrecy in the Fairholme proceedings and the court initially granted the government's request that 11,000 pages of materials be treated as confidential.  DOJ also asserted presidential privilege in 45 documents. Fairholme appealed that decision and in 2015 the NYT filed an amicus curiae brief asking that the judge unseal two of the depositions in the case to "enable the public to understand more fully the decisions the government has made in the public's name and to assess the wisdom and effect of those decisions."

In April 2016, judge Margaret M. Sweeney ordered some of the documents unsealed. They cast a quite different light on the 2012 changes to the agreement.

Among the documents were three excerpts from depositions taken in the case by Fairholme's attorneys. One was a deposition given to plaintiff's attorneys in 2015 by Susan McFarland, former Fannie Mae CFO. She stated she had told Treasury officials on August 9, 2012 that her company was "now in a sustainable profitability, that we would be able to deliver sustainable profits over time."   McFarland said that Fannie could soon reap about $50 billion in income because of the reversal of an accounting entry, known as a deferred tax asset, required under accounting rules when the company began earning profits again. Also unsealed was a copy of that presentation to Treasury which contained 10 years of internal financial projections from Fannie, indicating that the company would not require further assistance from taxpayers.

It was a little over a week after McFarland made that presentation that the new FHFA/Treasury agreement was revealed and McFarland said in her deposition that she believed her conversation with Treasury triggered the change. She said it was done to seize the GSE's profits, in part because of a desire not to allow them to recapitalize themselves.  

McSweeney also unsealed testimony from Mario Ugoletti, a former Treasury official and special adviser DeMarco.  In December 2013, Ugoletti signed an affidavit for the case stating unequivocally that neither the Treasury nor the Federal Housing Finance Agency envisioned that the companies' deferred tax assets were about to be reversed in the months leading up to the profit sweep, generating huge profits. He also said that agreement was not changed to "increase compensation to Treasury."  However, in his deposition Ugoletti said he did not know whether the Treasury or the Federal Housing Finance Agency officials knew about the potential for the profits at Fannie and Freddie at the time of the sweep.

Further doubt was cast on the government's assertion about the state of the GSEs' financial condition by a document produced by Grant Thornton, the accounting firm hired by the government to do financial analysis on the companies. It shows Freddie's financial results through the first quarter of 2012 alongside handwritten notes from an unknown Grant Thornton employee. That employee noted how Freddie's profits would require that it reverse the accounting entry, known as releasing the valuation allowance. Those notes supported consideration of this release, probably within one or two years.

This week the court ordered another group of documents unsealed, bringing the total to about 3,500. According to Morgenson, these show that as early as December 2011 high level Treasury officials, including the Secretary, knew that changing the dividend to a net sweep would likely generate more money for Treasury than the original terms.  Among the documents is a memo to Geithner from Mary John Miller, assistant secretary for financial markets, outlining "restructuring and transition options" for the GSEs. The number one option was swapping the dividend for a permanent net worth sweep and noting that Freddie Mac was "expected to be net income positive by the end of 2012 and Fannie by the end of 2013." Another draft memo recognized the increased revenue that would accrue through the change.

Morgenson says diverting profits into the Treasury also seemed to further its stated goal of winding down the companies, "an outcome that some contend could eventually put the housing finance system on a sounder footing."  She adds however that legal experts say pursuing that goal while the companies were under a form of government control called conservatorship flouted the Housing and Economic Recovery Act (HERA) of 2008 that led to the GSE rescue. HERA, which also set up FHFA as both regulator and conservator, directed the agency to preserve the GSEs' assets so they could operate independently in the future.  

A calculation by plaintiffs in another case against the government involving the profit sweep states that Fannie and Freddie have paid $130 billion more to the government than they would have under the original rescue plan.

Berkowitz said in a statement that the unsealed documents "prove that senior officials in the previous administration knowingly violated their statutory authorities and deliberately fabricated a tale to justify their unlawful actions."