Fannie And Freddie Investors Find A Silver Lining Amid Claim Dismissals

Federal National Mortgage Association FNMA and Federal Home Loan Mortgage Corp FMCC investors received more bad news last week when U.S. District Judge Royce Lamberth dismissed the majority of the claims against Fannie Mae and Freddie Mac in a shareholder lawsuit against the two government-sponsored enterprises.

Fannie and Freddie shares are down more than 51 percent in the past year as very little progress has been made in resolving their government conservatorship, but Height Capital Markets says the judge’s ruling does leave investors with a glimmer of hope.

Good Faith Violation

While most claims were dismissed, there was one major exception when Lamberth ruled that the GSE net worth sweep, in which the government seized all of Fannie and Freddie’s profits indefinitely, may in fact be a violation of good faith.

“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,” Lambert wrote in his ruling.

Height’s Take

According to Height, the dismissal of most of the claims was no surprise, but the good faith ruling will at least allow more light to be shed on the situation.

“His validation of the breach of good faith claim will allow this lawsuit to proceed, meaning the plaintiffs will be able to conduct discovery and review numerous government documents related to the conservatorship of the GSEs as well as the decision to implement the Net Worth Sweep,” Height wrote Tuesday.

If  Lamberth ultimately rules there was a breach of good faith, Fannie and Freddie investors could be entitled to financial damages and/or the GSE’s dividend payments to the government may be reverted back from 100 percent of profits to a 10 percent annual yield.

“We do not know how the court would address the overpayments in this instance, but the easiest path is to consider it a return of capital rather require the government to repay the funds,” Height wrote.

Recapitalization Is Key

Perhaps most importantly, a ruling of a breach of good faith may force the issue of recapitalizing Fannie and Freddie, which would be the first step in any process to releasing them from government conservatorship.

Regardless of the outcome, it will likely be a long process for investors. Last year, Height's Edwin Groshans estimated it would take roughly a decade for Fannie and Freddie to be adequately capitalized if they were allowed to begin retaining 100 percent of their earnings.

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