Elon Musk’s bid to get out of buying Twitter Inc. for about $44 billion goes to trial Oct. 17 in Delaware. The same day, another multibillion-dollar lawsuit that zeroes in on good faith when parties sign contracts will be heard in U.S. District Court in Washington. The investment firm Fairholme Funds Inc. is leading a group that claims U.S. government agencies shortchanged them $27 billion in the financial engineering that has its roots in the 2008 mortgage meltdown.
Two weeks before the collapse of Lehman Brothers, authorities agreed to bail out Fannie Mae and Freddie Mac, government-sponsored enterprises (GSEs) that greased the nation’s housing market. But the government couldn’t afford to take their liabilities onto its own balance sheet in a full-blown nationalization, so then-Treasury Secretary Henry Paulson proposed a conservatorship instead. The U.S. Treasury Department offered each of them up to $200 billion of capital support in exchange for warrants over 79.9% of common stock together with some preferred stock. Initially, the support carried a 10% cash dividend.
The situation was meant to be temporary. The press release accompanying the move said that it was “designed to stabilize a troubled institution with the objective of returning the entities to normal business operations.” That all changed in August 2012, when the government amended the terms of the bailout. The 10% dividend was canceled, and the companies were now required to hand over all their profits to the Treasury in a so-called “net worth sweep.” With the companies stripped of the right to retain earnings, any value left in their legacy junior preferred stock evaporated. Shareholders were not happy.
Fairholme and a number of other investors sued. The government claimed that Fannie and Freddie were in a “death spiral”—their profits were so weak they required support from the Treasury simply to make their payouts.
In a 2014 decision, Judge Royce Lamberth of the U.S. District Court for the District of Columbia sided with the government. “It was Congress, after all, that parted the legal seas so that FHFA [the body overseeing the housing companies] and Treasury could effectively do whatever they thought was needed to stabilize and, if necessary, liquidate, the GSEs.”
But a separate hearing entitled Fairholme to conduct fact discovery and it soon transpired that not all was as it seemed. The August 2012 amendment coincided almost completely with a turnaround in Fannie’s and Freddie’s fortunes. Having sustained losses every year between 2008 and 2011, the two began generating profits again in the first quarter of 2012. Projections—not initially declared in court—showed the profit trajectory continuing. “I believed we were now in a sustainable profitability,” said Susan McFarland, Fannie Mae’s former chief financial officer, in a deposition. An upturn in profit also paved the way for a writeback of deferred tax assets, worth around $50 billion for Fannie Mae.
The prospective turnaround undermined the “death spiral” rationale for diverting the dividends. “So when the amendment went into place,” McFarland testified, “part of my reaction was they did that in response to my communication of our forecasts and the implication of those forecasts, that it was probably a desire not to allow capital to build up within the enterprises and not to allow the enterprises to recapitalize themselves.”
Her analysis is supported by an email that Jim Parrott, then a senior White House official on housing finance, sent on the day the net worth sweep was announced. It was structured, he wrote, "so they can’t repay their debt and escape as it were.”
To Fairholme, it looked like the government could see massive profits ahead and conspired to take them all for itself without compensating stockholders. Indeed, by the time the sweep was finally turned off in 2019, the Treasury had received $301 billion in dividends from Fannie and Freddie, having made $191 billion of capital injections. “By imposing the so-called ‘Net Worth Sweep’ on Fannie Mae and Freddie Mac in August 2012,” Fairholme wrote in 2017, “FHFA enabled the United States Treasury to loot the Companies to the guaranteed exclusion of all other investors.”
Briefed with new evidence of what government officials were thinking at the time, Judge Lamberth changed his tune in 2018, paving the way for Fairholme to bring a claim for breach of implied covenant of good faith and fair dealing. “So while Plaintiffs could reasonably expect the GSEs to exercise discretion as it relates to dividends, they could not expect the GSEs to extinguish the possibility of dividends arbitrarily or unreasonably,” he wrote. “And at the nascent of a sustained period of profitability, Plaintiffs would have reasonably expected the GSEs to be moving out of conservatorship, not doubling down by executing the Net Worth Sweep.”
Next month, the sides are scheduled to meet in court. As with Musk, the cases should show that no one is above the law—not the richest man in the world, nor the U.S. government.
Marc Rubinstein is a former hedge fund manager. He is author of the weekly finance newsletter Net Interest.