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FHFA Says It Didn't Study Fannie, Freddie Profit Sweep Effect

By Katie Buehler

Law360 (October 20, 2022, 9:21 PM EDT) -- Former Federal Housing Finance Agency Director Edward DeMarco admitted to a D.C. federal jury Thursday that the agency didn't conduct any analysis or studies before allegedly improperly amending stock purchase agreements to allow the U.S. Treasury to sweep up Fannie Mae's and Freddie Mac's net worths.

Under sometimes tense questioning by attorneys for Fannie Mae and Freddie Mac shareholders, DeMarco testified that the FHFA didn't consult accountants, its own financial modeling division or its chief economist before agreeing in 2012 to amend the terms of the U.S. Department of the Treasury's preferred stock purchase agreements governing the companies' bailouts following the 2008 housing market crash.

The 2012 amendments, also known as the "net worth sweep," increased the department's dividend amount from 10% of its total investment to 100% of the companies' current and future net worths. Shareholders claim the move eliminated the prospect of them ever receiving dividends and resulted in the Treasury receiving $130 billion more in dividends than it would have under the original deal.

"Is there a single document analyzing the pros and cons of entering into the net worth sweep?" shareholders' attorney Hamish Hume of Boies Schiller Flexner LLP asked DeMarco.

"No," DeMarco said.

Three classes of Fannie Mae and Freddie Mac shareholders have accused the FHFA of breaching the implied covenant of good faith and fair dealing by agreeing to the 2012 amendments. They are seeking $1.6 billion in damages.

The FHFA has defended its decision, arguing in court that the "net worth sweep" was the only way it could get Fannie Mae and Freddie Mac out of a circular draw pattern in which they continuously borrowed more money from Treasury to pay the mandatory 10% dividend set out in the original stock purchase agreements.

If that cycle continued, the agency contends, Treasury's investment in the two companies would slowly erode, causing the housing market to lose faith in Fannie Mae and Freddie Mac and potentially leading to another crash.

On Thursday, DeMarco said the 2012 changes were also a way to avoid the implementation of a periodic committee fee on the companies.

The original bailout deal included a periodic committee fee — an additional fee on top of the dividends paid to the Treasury Department to compensate it for its investment in the companies — but Treasury had waived the fee for 2010, 2011 and 2012. DeMarco said he was worried the department would reinstate it in 2013.

The commitment fee was never calculated, but it was expected to be "potentially substantial," according to Fannie Mae and Freddie Mac's filings with the U.S. Securities and Exchange Commission.

DeMarco said he believed the commitment fee would equal the companies' net worths, so he negotiated the "net worth sweep" instead, which permanently suspended the fee.

"I believe the net worth sweep enhanced the stabilization of the companies," he said.

The "net worth sweep" would also forward DeMarco's plans to shrink the companies and reconstitute them so that they could operate as private entities.

The shareholders have argued that DeMarco's plans were driven more by his political views that the government shouldn't be involved in the secondary housing market, rather than the publicly stated aim in 2008 to return Fannie Mae and Freddie Mac to profitability. But he claimed it was within his authority as then-acting FHFA director to take steps toward his plan.

"As long as I was director, I was committed to my publicly stated plan," he said. "I knew every day I showed up to work I could be replaced. But if I let that dominate my decision-making, what decisions would I have made?"

Jonathan Stern of Arnold & Porter, representing the FHFA, pointed out to the jury that Fannie Mae and Freddie Mac's futures didn't look as rosy in 2012 as the shareholders claim they did. The companies both filed quarterly SEC reports that summer stating they would be unlikely to make enough money to pay the Treasury Department its dividends without borrowing more money.

"We were going to be in a world of future circular draws," DeMarco said.

Stern will continue to cross-examine DeMarco on Friday as well as ask him questions typically asked on direct-examination. The parties agreed before trial to only call DeMarco once and to use a hybrid style of questioning.

This dispute stems from the housing market crash of 2008 and Congress' passage of the Housing and Economic Recovery Act that year, which created the FHFA and empowered it to act as a conservator for Fannie Mae and Freddie Mac when necessary. The FHFA placed the companies under an allegedly temporary conservatorship in September 2008, with the publicly stated aim of stabilizing their finances and restoring them as private entities.

As part of the conservatorship, the companies entered into senior preferred stock purchase agreements with Treasury, entitling the department to a liquidation preference and quarterly dividends equal to 10% of its total investment in the companies, according to the shareholders' lawsuit.

By mid-2012, Fannie Mae and Freddie Mac had recovered significantly and returned to profitability, with the potential of exiting the conservatorship by 2020, according to the lawsuit. Instead of continuing with the terms of the conservatorship, the FHFA and the Treasury Department implemented the "net worth sweep."

The stock purchase agreements have since been amended several times to allow Fannie Mae and Freddie Mac to keep some profits while the department's first-in-line liquidation stakes in the companies grows.

The Treasury Department has invested $191.4 billion in the two companies since 2008 and has received $385.3 billion in return, according to investment data presented at trial.

The shareholders are represented by Hamish P.M. Hume, Samuel C. Kaplan and Kenya K. Davis of Boies Schiller Flexner LLP, Eric L. Zagar and Lee Rudy of Kessler Topaz Meltzer & Check LLP, Michael J. Barry of Grant & Eisenhofer PA, and Adam Wierzbowski of Bernstein Litowitz Berger & Grossmann LLP.

The FHFA is represented by Asim Varma, Howard N. Cayne, David B. Bergman, Ian S. Hoffman, Jonathan L. Stern and Robert Stanton Jones of Arnold & Porter.

Fannie Mae is represented by Meaghan VerGow of O'Melveny & Myers LLP.

Freddie Mac is represented by Michael J. Ciatti of King & Spalding LLP.

The case is In re: Fannie Mae/Freddie Mac Senior Preferred Stock Purchase Agreement Class Action Litigation, case number 1:13-mc-01288, in the U.S. District Court for the District of Columbia.

--Editing by Adam LoBelia.