Carney: Supreme Court Gives Little Comfort to Fannie-Freddie Investors

Shares of Fannie Mae and Freddie Mac jumped higher Wednesday as arguments kicked off at the U.S. Supreme Court in a lawsuit brought by shareholders over hundreds of billions of dollars in payments made to the U.S. government.

Investors should be cautious about chasing stock higher based on the hearing. And, in fact, many were. The rally that sent shares to their highest level since February, up around 20 percent, soon faded and shares dropped down to a more level-headed five percent gain. The hearing gave little reason for investors to expect the court will vindicate shareholder claims that the government illegally swiped as much as $124 billion of profits that should have gone them.

Chief Justice John Roberts helped spark the initial rally when he kicked off the questioning of the government’s attorney by asking him to respond to the claim that the government’s actions had “completely wiped out” the shareholders. He followed up with a series questions challenging the government’s claims that shareholders were not directly harmed by a 2012 agreement between the Treasury Department and the Federal Housing Finance Agency that directed all of the profits of Fannie and Freddie to the U.S. government’s coffers.

Later, however, Roberts seemed to take the other side of the argument, telling shareholders’ attorney David Thompson that he had just looked up the price of the shares that morning and saw that the shares still had a market value.

“Your shares are not worthless,” Roberts said. “They’re worth something, presumably largely based on judgments about what the future holds. So doesn’t that render your sort of nationalization rhetoric just that, rhetoric?”

What’s more, Roberts went on to describe the 2012 agreement as “a lifeline thrown to your clients.”

Fannie and Freddie do not make home loans. They buy mortgages from banks, bundle these into securities to be sold to investors, and guarantee timely payments to buyers of the securities. This is intended to provide liquidity to the mortgage market and is thought to be central to the ability of lenders to offer fixed rate, 30-year mortgages, a home loan product not offered in most markets outside the U.S.

For years, the two companies were immensely profitable because investors believed that they were implicitly backed by the U.S. government, making their mortgage guarantees as safe as sovereign debt. Some lawmakers and the companies themselves denied that there was any implicit backing but when the companies teetered on the verge of collapse in 2008, they were taken over by the FHFA and Treasury extended an unprecedented and — for a time —unlimited line of capital to the two companies. This allowed the two companies to make good on all the guarantees they had extended and to provide liquidity to the mortgage market even at the height of the financial crisis.

In exchange for the bailout, Treasury received warrants to buy nearly 80 percent of the common stock and a special class of stock that paid a 10 percent dividend. In addition, the companies agreed to pay a commitment fee on the ongoing backstop facility provided by the government.

The government would eventually pump $190 billion into the firms, nearly half of the $400 billion ongoing bailout facility. Some of these funds were actually used to pay the 10 percent dividend because the profits earned by the companies fell short of the required amount. The result was what became known as “a circular draw,” with the companies taking money from the Treasury that was used to pay the dividend to the Treasury.

This was not only silly, it was also potentially dangerous. The government’s authority to increase the amount of capital available to the companies had expired in 2009 and become fixed at $400 billion. Each new draw diminished the amount available. Officials in the Obama administration worried that at some point the market would become concerned that the two companies could fall into distress again.

To avoid this, the Treasury and the FHFA amended the agreement in 2012 to end the circular draws. Instead of a fixed 10 percent, the companies would pay a flexible dividend equal to their positive net worth less a small cushion.  As a result, the companies are obligated to pay nearly all their profits to the Treasury. In lean quarters, the companies have paid less than they would have under the original arrangement. In profitable quarters, the companies paid more. All told, Fannie and Freddie have paid more than $300 million to the government in dividends.

Shareholders brought numerous lawsuits objecting to what has become known as the “net worth sweep.” Most federal courts tossed the suits on the grounds that the sweep was authorized in the broad grant of powers Congress included in 2008’s Housing and Economic Recovery Act. After a Fifth Circuit appeals court did the same, a deeply divided en banc panel of the court ruled in favor of shareholders on some of their claims. The Supreme Court agreed to hear the case.

Very little of the questioning from the justices on Wednesday focused on the statutory questions in the case, including whether the FHFA is permitted to send nearly all of the profits of the companies for which it is acting as conservator to the Treasury. That likely signals that the court is unlikely to rule that the FHFA or Treasury overstepped their legal authority when they created the net worth sweep. If the court was preparing to rebuke the government for stepping outside the role of conservator or overstepping its statutory power, justices would likely have focused more questions on this issue at the government attorney.

Instead, the justices focused many of their questions on another issue in the lawsuit: whether the structure of the FHFA violates the constitution. Under the authorizing statute, the sole head of the FHFA serves for a fixed five-year term and can only be removed by a president “for cause.” This is meant to isolate the agency from political pressure but it mirrors the single-director structure of the Consumer Finance Protection Bureau (CFPB) that the Supreme Court in an earlier case declared was unconstitutional on the grounds that it put too much executive branch power in the hands of an officer not answerable to the president.

In a twist, the Trump administration decided that it agrees with the shareholders that the structure is unconstitutional. As a result, the court had to appoint an attorney to defend the agency’s structure against arguments by the attorneys for both the government and the shareholders. This was a thankless task. Several of the justices, including some of the liberals, appeared to assume that the structure would be found invalid based on the CFPB precedent. Justice Samuel Alito, however, hinted that the court might be able to skip past the issue altogether because the 2012 agreement was made by an acting director who could have been removed by the president.

The justices appeared to be skeptical about the shareholders’ proposed remedy for the unconstitutional structure, namely that the payments made under the net worth sweep should be deemed to reduce the amount of the government’s investment in the companies and future dividend payments be enjoined. The en banc panel in the Fifth Circuit ruled that the structure was unconstitutional but declined to provide any remedy to the shareholders for that, instead sending the question down for a trial.

“What you are asking for is counter-intuitive and perhaps illogical,” Justice Sonia Sotomayor said. “Why should you get more than a declaratory judgment?”

“Do you think that if a provision of a massive statute is held to be unconstitutional, a person who is not in any way affected by that provision is entitled to relief?” Justice Samuel Alito asked.

The 100-minute argument featured tough questions for all three attorneys involved and there was no clear cut winner. But predictions by analysts that conservative justices would almost certainly view the government taking all of the profits of Fannie and Freddie as appalling were not borne out Wednesday’s hearing. Certainly, nothing in the hearing is likely to convince the government that it needs to settle the lawsuit or reach a consent agreement to end the sweep before the court renders its judgment several months from now. Based on Wednesday’s arguments, it seems likely that the Supreme Court will follow the Fifth Circuit en banc panel on the structure question — holding the FHFA structure unconstitutional but awarding no real remedy to the shareholders — while declining to strike down the 2012 amendment.

Fannie and Freddie may someday be free from the yoke of government control and the requirement to pay their profits to the Treasury. Wednesday’s Supreme Court hearing, however, gave little reason to expect that day is coming soon.