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New COFC GSE Lawsuit Challenges Conservatorship

Oct. 05, 2021 12:22 AM ETFederal Home Loan Mortgage Corporation (FMCC), FMCKJ,FNMA,FNMASFMCCG, FMCCH, FMCCI,FMCCK,FMCCL,FMCCM,FMCCN,FMCCO,FMCCP,FMCCS,FMCCT,FMCKI,FMCKK,FMCKL,FMCKM,FMCKN,FMCKO,FMCKP,FNMAG,FNMAH,FNMAJ,FNMAK,FNMAM,FNMAN,FNMAP,FNMAT,FNMFM,FNMFN,FNMFO,FREJP10 Comments2 Likes
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Glen Bradford
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Glen Bradford MBA contributes to Seeking Alpha primarily to read people's negative feedback so that he can avoid generating unnecessary losses. "Uncertainty will certainly work for me." - Glen Bradford March 2009.

Glen wishes you a bright sunny warm day filled with smiles, laughter, and love.

The Supreme Court got it wrong, which is sad, but it's not over yet.

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.
Burglar running away with bag of money
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 (NYSE:JPM) and Morgan Stanley (NYSE: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.

This article was written by

Glen Bradford profile picture.
Glen Bradford
4.47K Followers
Glen Bradford MBA contributes to Seeking Alpha primarily to read people's negative feedback so that he can...
http://www.glenbradford.com
Value, Growth At A Reasonable Price, Long-Term Horizon, Portfolio Strategy

Contributor Since 2008

Glen Bradford MBA contributes to Seeking Alpha primarily to read people's negative feedback so that he can avoid generating unnecessary losses. "Uncertainty will certainly work for me." - Glen Bradford March 2009.

Glen wishes you a bright sunny warm day filled with smiles, laughter, and love.

The Supreme Court got it wrong, which is sad, but it's not over yet.

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.

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