Fannie And Freddie Investors Hope New Unsealed Court Documents Are The Smoking Gun They Need

The latest chapter in the Federal National Mortgage Association FNMA and Federal Home Loan Mortgage Corp FMCC drama unfolded this week after a new batch of government documents were released that investors believe provide evidence of the illegality of the Treasury’s “net worth sweep” of Fannie May and Freddie Mac’s profits.

Back in February, Fannie and Freddie shareholders suffered a major blow in the courtroom when an appeals court ruled that investors could no longer pursue legal claims against the U.S. government related to the government’s “net worth sweep” of Fannie and Freddie’s profits. Shareholders have argued that the government illegally amended the terms of Fannie and Freddie’s conservatorship, and that shareholders have a legal claim to Fannie and Freddie’s profits.

February’s defeat was one of several shareholder lawsuits that have been dismissed. However, a judge in one of the lawsuits recently allowed limited discovery, resulting in a new batch of government documents being unsealed for the first time.

New Evidence

Fannie and Freddie shares surged this week as investors zeroed in on a handful of documents that they believe prove the government acted illegally in instituting the net worth sweep.

The shareholder case seems to hinge on proving that the government was aware that there was no risk of Fannie and Freddie falling into a “death spiral” at the time the terms of their bailouts were amended in 2012. In a death spiral scenario, Fannie and Freddie would not be able to pay the full 10-percent dividend owed to the government under the original bailout terms without relying on bailout funds to do so.

In one newly unsealed document, a Treasury official says the GSE’s regulator told Treasury Secretary Timothy Geithner that Fannie and Freddie “will be generating large revenues over the coming years, thereby enabling them to pay the 10% annual dividend well into the future.”

In another document, Former Treasury official Benson Roberts wrote that the argument that the 10 percent dividend would be unstable “doesn’t hold water” and that Fannie and Freddie’s businesses “won’t reduce in the immediate future.”

Smoking Gun?

Shareholder attorney Pete Patterson told reporters on Tuesday that the new documents show that the Treasury “understood that there was no threat of a death spiral at the time the net worth sweep was adopted.”

Others aren’t convinced the documents will be a game-changer. Bloomberg Intelligence analyst Elliott Stein said the release of similar documents in the past hadn’t changed the courts’ minds.

A Washington Wildcard

Even without a favorable ruling in the courtroom, investors have been hoping Treasury Secretary Steve Mnuchin will opt to begin the process to recapitalize Fannie and Freddie and return the GSEs’ income to shareholders.

In the past, Mnuchin and President Donald Trump have said housing finance reform is a top priority but have provided few details as to what that reform may entail.

Related Link: Will The FHFA Suspend Fannie & Freddie's Dividend Payments To Treasury?

Earlier this year, Height Securities analyst Edwin Groshans cautioned investors about placing too much hope in Mnuchin.

“The extraordinarily long time it would take the GSEs to achieve a risk-based capital requirement would prohibit the entities from making any dividend payments to shareholders for a decade or longer,” Groshans explained. “This differs materially from taking a trading position to capitalize on a potential change to the dividend payment frequency or the less likely scenario of the GSEs retaining some capital.”

Groshans estimates Fannie Mae would need roughly $26.3 billion in core capital and Freddie Mac would need $16.2 billion in core capital under the now-suspended risk-based capital requirements for financial institutions.

After a big post-election surge on hopes that the Trump administration would return control of Fannie and Freddie back to shareholders, both stocks are down more than 33 percent in 2017.