New COFC GSE Lawsuit Challenges Conservatorship

Summary

• Banks are challenging the imposition of conservatorship, arguing that the statute of limitations was tolled between June 2013 and July 2020.
• Plaintiffs argue that the imposition of conservatorship was an unlawful taking and/or illegal exaction in violation of the United States constitution.
• Plaintiffs bring both direct and derivative claims.

fergregory/iStock via Getty Images

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that were placed into conservatorship to protect the banking system in 2008. In 2012 the government arranged for the net worth sweep, taking all of the companies' profits that they previously hid (2008-2011) on their balance sheets for nothing. Shareholders filed lawsuits mostly around the net worth sweep, but only Washington Federal challenged the conservatorship itself. Not anymore! A new lawsuit was filed in the court of federal claims October 1 on behalf of Michael Kelly and a handful of banks. The purpose of this article is to outline some key parts of this lawsuit.

Investment Thesis

In the event that the Biden administration continues to let Fannie and Freddie recapitalize, they will probably want to restructure their balance sheets so that they can monetize their equity investment as part of ending conservatorship. In this outcome, the lawsuits will apply pressure on behalf of shareholder stakeholders that will justify their equitization in a capital raise. The banks filing this lawsuit owned just under $1B of GSE preferred shares when the conservatorship was imposed. This new lawsuit could result in a huge win for shareholders, or lead to favorable settlement terms. In the event preferred are exchanged on a par basis for common in an equity restructuring, their upside is 10-15x depending on which series you are looking to own. Earlier this year, these shares were sold down more than 50% on the Supreme Court ruling that said the government can do whatever it wants. Shareholders selling seem to think that the courts are never going to make anything good happen for shareholders at these valuations, which are basically call options on the future of the companies, which happen to be thriving and on their way out of conservatorship.

Kelly v. The United State of America

Here is the TOC of the lawsuit:

It seems to me that the basic crux here is that these banks invested around a billion dollars into Fannie and Freddie pre-conservatorship based on public statements and good faith. Then, the government basically took over the companies by coercion:

Plaintiffs argue that it isn't that Fannie and Freddie needed government help, it is that the government came in and took over by threat. Hank Paulson wrote the entire story in a book.

The plaintiffs argue that foreign interests are what caused the government to take over Fannie and Freddie:

Plaintiffs argue that they are able to get around the six-year statute of limitations:

Plaintiffs argue that the government can take property under the constitution but when it does it must provide just compensation:

Plaintiffs argue that the government breached its implied regulatory contract:

I really like this claim. It is true that the companies were just given a clean bill of health, and then the government basically went after them and took them over.

Plaintiffs then ask the court to say that the government illegally took their private property, award them damages for takings and breach of implied regulatory contract as well as interest:

This lawsuit, if it isn't dismissed and gets past the statute of limitations, is a can of worms for the government. In theory, it could cost the government $1B to the plaintiffs alone plus 13 years of interest and who knows how much in damages and those are just the direct claims.

Summary and Conclusion

This lawsuit opens the gate for preferred shareholders attacking the imposition of conservatorship. This lawsuit raises new challenges from a new perspective, regulatory breach of contract. These are the sorts of perspectives I've been writing about on Seeking Alpha for seven years; that the government did a hostile takeover of the companies and that the takeover was not done to benefit the companies, because they didn't need it and Hank Paulson bragged about how he got away with it. I was kind of disappointed to see that Dan Jester was not quoted in this lawsuit as the man to reconstruct the record to retroactively justify the takeover by loading the companies with accounting losses to prove their point that the takeover was not valid, but I'm not a lawyer.

In an equity restructuring that leads to the recapitalization of Fannie and Freddie via capital raises led by their underwriters JPMorgan (JPM) and Morgan Stanley (MS), I expect preferred to be exchanged for common on a par valuation, or perhaps better if the government wants to test the validity of these legal challenges. I figure common are worth $3-10 depending on the capital requirements that FHFA eventually decides to keep as part of monetizing the government's equity position.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of FMCCG,FMCCI,FMCCJ,FMCCN,FNMAO,FNMAP,FNMFO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I do not own common stock. My family and friends own preferred stock and some common stock.

Comments

[agretoo]

"Are Fannie and Freddie still in conservatorship?

Until Congress determines the future of Fannie Mae and Freddie Mac and the housing finance market, FHFA will continue to carry out its responsibilities as Conservator."

Fannie Mae and Freddie Mac paid back even $300 billion for $190 billion of the government’s conservatorship. Isn’t the conservatorship over? How can Congress decide to keep the Conservatorship? What kind of country is the U.S?

[mag1205]

@agretoo

Under the NWS $300 Billion treasury got from GSE's is NOT reducing $190 Billion given in the first place by treasury under the so called AMENDED CLAUSE they inserted in 2012.

As such we still owe treasury $190 Billion as per FHFA & Treasury because SCOTUS said that Govt. can do ANYTHING with GSE's?

Waiting for Judge Lamberth's jury trial in July this year.
My ONLY hope left.

Long Fannie since early 2008

[mag1205]

@agretoo

"What kind of country is the U.S?"

Just like any other bannana republic where our two profitable companies are practically NATIONALIZED without giving a dime to it's investors.

[Omava]

@mag1205 Lamberth is a dog of the government.

[mag1205]

FF stock is the lowest and I am buying at these 60 to 67 cents.
How far it can go?
5% chance it might go to 50 cents
95% chance it will go over a dollar by end of July.

[100Millionman]

Fannie and Freddie must pay their investors dividends. Fannie and Freddie can’t use the private investment free anymore. It is illegal.

[Omava]

@100Millionman
Net Income 2021: Fannie Mae - $22.2 billion,
Freddie Mac - $12.14 billion
Net Income 2022/1: Fannie Mae - $4.4 billion
Freddie Mac - $3.8 billion

But the stocks of Fannie Mae and Freddie Mac lost their value to $0.65 and $0.62 because they don't share their profits with their stockholders.
Every company shares its profits with its stockholders, but Fannie Mae and Freddie Mac have never shared their profits since 2008. It is out of the law.

[mag1205]

@Omava

There is NO justification what so ever keeping GSE's under Govt. conservatorship for almost 14 bloody years when FF are the TWO best run companies.

But Thank God, FF are retaining their profits and that is a good thing in my opinion even though some of these profits should be shared with FF investors.

[Omava]

Fannie Mae and Freddie Mac have only saved dividends every quarter. And there is no reason to lose their stock value, but they have only lost their stock price and paid no dividends at all.
Isn't it something wrong? I can see the F/F's intention to kill their investors.

[mag1205]

@Omava

There is really no rationale for FF stock price to fall to 70 cents level unless jury trial in Judge Lamberth's court finds that FF was bankrupt when it was put into conservatorship in September of 2008?

I for ONE believes that there is much higher value in FF stock compared to it's current value.

BTW I have been long Fannie since early 2008.

[100Millionman]

Who does believe Fannie Mae and Freddie Mac, and the government? What is a stock? Fannie and Freddie are thieves like the government who sucked 100% benefits without sharing the other investors.

[PHILIP MAX]

Here's my take on the courts in the USA. Judges are locked in with vested interests (in our drama it's the banks). the judges will sit on the issue as long as possible, (many times for many years). When public pressure pushes them to act, they will find the flimsiest, most inconsequential, minutia point of law to sway the case in favor of their masters. In the case of FnF, the plaintiffs have it all on their side - dead -to-rights law, moral, justice and fair play. Therefore, the judges have to carefully wait for the right moment to catch plaintiffs off guard and pounce with a very negative ruling against them.
So, while we the shareholders are sweating it out, the judges and the banks are out ion the golf course planning our demise. And, yet...I am still holding on. I must be stupid!

[mag1205]

@PHILIP MAX

Yes, judges are biased but are all judges REALLY biased?
I don't think so.

Judge Lamberth has Mario Ugoletti's false statement & NOW correction in his court.

How can he NOT see Govt. (FHFA & Treasury) lying through their teeth?

Justice WILL prevail.

Long with my darling Fannie since 2008

[PHILIP MAX]

@mag1205 it’s in large awards in civil courts where the big payoffs are egregious. Perhaps in criminal courts where there is less money on the table, it’s easier to follow the law. But where money on is on the table, especially public money, such as our case is, there is enough on the table to feast on. Not that the the judges are necessarily on the take, to them, ingratiating the wealthy could be just as rewarding. Not a blanket statement , but, enough to be noticed.

[Valuemonster]

The JPS have definitely found a bottom, and would not be surprised with 20/20 hindsight to see many 'Dems (Pelosi, Waters, et al) 'accumulating.' If the Infrastructure & Social spending get hammered down as looks likely to happen, then the $100B+ in warrants, et al, look like a decent source of funds for Biden. Something could get 'done' sooner than expected in terms of a settlement IMO.

Note: just today, as has happened in the past say 1-2% of the time, FMCC (Common) is trading higher than FNMA. Go figure.

Cheers & Great luck, VM

[mag1205]

@Valuemonster

How can Dems be so stupid not to cash in their 79.9% illegal stake in FF?
Let's hope Bernie changes few minds to get extra money for his social infrastructure.

[bigjohn327000]

@mag1205 because imo it would cause another round of lawsuits....

[bellbottomblues]

Does anyone believe GSEs are a priority for this admin/congress? Status quo is a-ok for 99%+ of Americans who think Fannie Mae is a candy store in Chicago. Eventually a decision will get made here but that could literally be years from now and is as likely to benefit gov. or no one as it is to benefit GSE investors.

[John Clark Martin, Esq.]

I sold out of my FNMA a few years ago after seeing my investment slowly decline. I'm glad I did. Looking forward to reading Glen's book in another decade on Fannie and Freddie. Unlike Brittany, I see no hope for Fannie to escape her conservatorship.

[Wxk3]

@John Clark Martin, Esq. I dunno. The government is in serious debt. Why wouldn't they sell an asset that's doing nothing for them and capitalize on it? It almost seems irresponsible not to. Its easier than raising taxes. Look at how many institutions that were in trouble are now back in business. AIG, All the major banks etc.Why are FMCC and FNMA so bad comparatively.

[mag1205]

@Wxk3

Because FF is cash cow for Govt. It's going to stay under FHFA & Treasury for a long time even IF Judge Lamberth or Stephen S. Schwartz come out in favor of FF investors, democrats will appeal it for years down the road in my opinion. I see no end to this longest conservatorship in the history of the U.S.

[dusty1]

@mag1205 If its a cash cow why are they hiding it in the barn instead of milking it? Its doing relatively nothing for them now in the zombie state. There are a lot of ways the Government could get value from them. If you were them - wouldn't you try to cash out the seniors or exercise the warrants? Agree that, in terms of the litigation they will stretch this out as this is the DOJ swim lane. This is what they do and have infinite resources compared to any client. You don't want to be the Civil Division attorney that throws in the towel - that certainly would not be career enhancing!

[dave2015]

Freddie and Fannie are the goose laying the golden egg. The Dems WILL NOT give them up...voluntarily or not. They hold over 70% of all mortgages. To big to fail...(MAYBE ANOTHER GOVERNMENT BAILOUT IN THE FUTURE) that's why they were stolen and not to be returned anytime soon. Even the SC went against, what was the right thing to do. I was loyal to them for 11-years. I can't deal with thieves and Government thugs. Biden has no say in this anymore then Maxine Waters. I will wait and see what happens after Biden and Harris are out. If I waited 11-years, what's another 3-years. I parked my money in a SP-500 index fund to make up my loses. I've lost my trust and patience with our current government. THIEVERY SHOULD NOT BE REWARDED ! PERIOD !

[100Millionman]

@dave2015 Not only the government but also Fannie and Freddie were thieves. F/F have never complained against the government and never paid even $1 for their private investors since the Financial Crisis in 2008.

[gdacostap]

@100Millionman You're blaming the victims.

[mag1205]

@dave2015

GSE's are going to stay in conservatorship for a long time because Biden administration has no plans to deal with it. Maxine Waters is too strong & vocal in basically giving every Tom, Dick & Harry a house with or without any income to pay minimum mortgage payments in my opinion.

I am long Fannie since early 2008 & can afford to wait few more years until Biden is out of office in 2024.

[Da BuLL]

Beyond tired of cronies and banksters pillaging the little guy.. in this case the helpless shareholders.. who r tied, bound, duct taped over lips, dying off penniless while they should be enjoying the bounty and the fruits of their labors and investment.. pure theft period.

[mag1205]

@Da BuLL

Pure illegal theft of our FF by Hank Paulson who saved his greedy Bank buddies and put FF into conservatorship & after 13 bloody long years we are still no closer to getting this conservatorship end for long suffering FF investors.

Long Fannie since early 2008

[bellbottomblues]

The fact that you might win the lottery doesn’t mean you should play.

[steven haffner]

@bellbottomblues You seriously believe this is a lottery ticket? With a trial scheduled after remand, Takings claims still pending and both companies retaining enormous quarterly profits for the past couple of years? Of course this is not a "safe" investment, but it is far from a lottery ticket. What is your agenda here?

[bellbottomblues]

@steven haffner yes I do think it’s a lottery ticket in the sense that a win is highly uncertain and a loss might be a -100% return. This range to me does not justify a big weight, if any, in a portfolio. My view is that the odds are stacked against investors, though I can’t prove it because it will be human beings that make the decision. Therefore, odds are unknowable.

[distressbuyer]

@bellbottomblues I'm long both common and preferred BUT yes....it's a lottery ticket. Why?:

>Regulators ideologically opposed to F&F in the past (Calabria)...w/the distinct possibility of the next regulator being "unsophisticated"/pliable when it comes to what does and doesn't constitute adequate capital and other intricacies relating to F&F.

>Courts - More evidence of ideological opposition....to wit - Alito's disregard for the facts in the recent US Supreme Court opinion. Let's see.....we win at trial and maybe at the appellate court levels BUT no problem.....kick it up to the Supremes and watch them continue to find a way to go against shareholders.

>Congress - A total circus but so many long knives still being held by the "bank captured" slime there.

Sure Mrs. Lincoln....But other than that, how was the play?

[PHILIP MAX]

It looks like the Market Makers are reluctant to let these stocks linger under $1 and get delisted from the over-the-counter market. In the last few days they really pumped it up. Let's see if this is just a market maneuver or something is brewing in the backrooms.

[steven haffner]

@PHILIP MAX Given the volume, I see this more as one or more buying programs. At $1 and certainly at .70 recently, these stocks are ridiculously undervalued and on their way up. Our SA legal experts opinions to the contrary notwithstanding.

[bellbottomblues]

@steven haffner this may just be volatile penny stock trading and nothing more.

[mag1205]

Something is cooking and FF took a nice jump.
We need few more such FF jumps.

[steven haffner]

@mag1205 I picked up more FNMA a month or two ago at .82 and wrote here recently I was going to pick up more at .62. However, a few days ago I saw a spike from .70 to .75 on very heavy volume and jumped in, reading this as evidence some monied parties made the decision to acquire or add a big position.

[mag1205]

@steven haffner

It was a big rally just before closing markets yesterday and I smell some nice cooking smell coming from back room negotiations between FF and FHFA. Remember FF hired financial firms last year for recap, may be we can finally see FF inching upwards from here on?
I am glad it's over a buck this morning.

Cheers for picking up FNMA at 82 cents. I picked up 10k at 98 cents.
Ha Ha Ha

[steven haffner]

@mag1205 Thanks for the cheers, but don't forget I also picked up a bunch the other day at .75. Despite SCOTUS' recent limited ruling, these stocks have significant upside, legally and politically/administratively. Among other favorable facts, have they not been retaining profits for numerous quarters?

[bigfish1977]

The justices literally asked "Why didn't you file the lawsuit as a takings case?" Because that's what it is. They took all the profits. Am I the only 1 that this seems like the logical path?

[cavlogix]

You still have shares, so the takings case loses. Only until the shares are worthless can a takings case proceed.

[cavlogix]

If the shares are canceled, then the takings case is validated, that is unfortunately why this case is not proceeding.

I am a long-term shareholder. it is going to come down to Democrats trying to force through affordable housing, or a Republican admin. tring to get a recap/release with less affordable housing payments, both sides will capitalize warrants...who gets there first and first what reason is the $$$ question.

[Rainman 06]

@bigfish1977
I will never understand why they did not as well

[Same Old Galo]

Up $.22 at the close?
What the heck just happened??

[daro]

The other question is what is the just compensation for the taking? Even if they win, when Fannie and Freddie were taken they were insolvent. There is no explanation for the “just compensation” part or what the recovery could be.

[mag1205]

@daro

"when Fannie and Freddie were taken they were insolvent."
Who are you kidding?

FF were NOT insolvent when Hank Paulson put them into conservatorship to save dirty asses of his Banker friends.

Stop listening or reading garbage dished out by DOJ Lawyers or FHFA or Treasury all in cohort to take over TWO well financed & well run private companies.

[bigjohn327000]

@daro actually they were not insolvent according to court papers

[steven haffner]

@daro Wrong.

[daro]

What is the argument that the statute of limitations was rolled. Not stated or explained in article.

[daro]

@daro tolled not rolled

[7716391]

"A new lawsuit was filed in the court of federal claims October 1 on behalf of Michael Kelly and a handful of banks." Okay, so exactly who are these banks? Joe Blow Savings and Loan? Huckleberry Credit Union? Slushenfunder Community Bank?

Nope? Well unless those handful of banks have initials like GS or JPM or BA, these new lawsuits have about as much chance of going anywhere as my uncle has of being my aunt. Well, these days, maybe that's not such a great example.

[steven haffner]

@7716391 I understand the cynicism. But can we be spared all of these legal evaluations by non-experts?

[mag1205]

@7716391

These law suits are keeping FF in the news and MAY BE we get lucky in Judge Lamberth or Schwartz's (replacement for judge Sweeney) 5th circuit court?

Long Fannie since 2008

[dave2015]

@steven haffner ...its clear in what he is saying .Who are these banks?? Identify them. Banks since 2009 don't have a lot of skin in the game. Unless its JPMorgan Chase this will be another wasteful lawsuit that will be thrown out. Maybe we will learn something new...this keeps the F&F story alive. In fact FNMA Commons had the biggest day since August...up 4 cents.

[PHILIP MAX]

We are living in a strange time zone (perhaps twilight). Whereas, in the past, the Courts were serving the constitution and seeking true justice, today, we sit with baited breath 'hoping' for justice. Whereas, before, Congress represented the will of the people, today, they represent vested corporate interests. Whereas, in the past, the President was a respected world figure, today, he is daily figure of ridicule. Lastly, the 'Fourth Estate', the hallmark of a free society, the Media, is a biased jumble of misinformation, lies, deception and ignorance. We can no longer trust our leaders, judges, and the press.
I wish that I can state with certainty that the courts of SCOTUS, Lambert, Sweeny, will follow the rule of law, seek the truth, and pursue Justice, but, alas, there is no assurance. Thus, all the faith and trust that we should rely on the SYSTEM are not working. New and stupid concepts of life and regulations are thrown at us as though issued by God, and we meekly observe these ridiculous dictums.
So, anyone investing in Fannie or Freddie has to be ready to lose it all. Maybe, in the current scheme of things it matters not, since the DOLLAR is about to be devalued into oblivion and ALL investments are an exercise in futility,
That, my friends, is my current most optimistic view of our world.

[bellbottomblues]

@PHILIP MAX GSE holdings are a coin toss, you are right about that. I don’t think the “old days” were as rosy as you describe though, nor today’s world so different. Just more of the same and you see as you get older that it never was anything but a stage with actors on it. Government, business, media, is nothing but people winging it like you and I. Not much to do but accept that reality.

[mag1205]

@PHILIP MAX

Agree 100% with you PHILIP MAX

"I wish that I can state with certainty that the courts of SCOTUS, Lambert, Sweeny, will follow the rule of law, seek the truth, and pursue Justice, but, alas, there is no assurance."

This I agree more that perhaps this time Judge Lamberth might be our savior.

[steven haffner]

@PHILIP MAX Well said. There are plenty of reasons to be cynical.