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News: Berkowitz: Treasury’s Rationale for Fannie Bailout Fix Is ‘Nonsense’
By NICK TIMIRAOS | March 10, 2014

http://blogs.wsj.com/moneybeat/2014/03/10/berkowitz-treasurys-rationale-for-fannie-bailout-fix-is-nonsense/

Bruce Berkowitz made clear in letters to the boards of Fannie MaeFNMA +4.50% and Freddie MacFMCC +3.50% two weeks ago that he believes the companies should be run for the benefit of private shareholders and not just the government.

But those letters raised an intriguing claim that received less attention: Mr. Berkowitz said the companies don’t need to pay the U.S. government its required dividend payments in cash and could instead do so with non-cash payments by issuing more stock to the government. This alternative, he said in an interview, undercuts the government’s entire rationale for controversial changes that it made in 2012 to the companies’ financial support.

First, a little background: The Treasury Department rescued the two mortgage companies from likely collapse during the financial crisis in 2008, agreeing to inject massive sums of aid and initially taking a 10% dividend on those stakes in exchange.

But the government changed those terms in 2012. The changes force the bailed-out firms to send all of their profits to the U.S. Treasury as dividend payments, replacing the fixed 10% dividend with this so-called profit “sweep.” Mr. Berkowitz’s Fairholme Funds has filed two different lawsuit challenging the legality of the sweep, joining more than a dozen other investors.

In legal filings last year, the Treasury said it made that change because of concerns that Fannie might ultimately exhaust the hundreds of billions in aid the government had pledged in order to pay the 10% dividend, which would trigger receivership. The 2012 amendment—the third such amendment to the government’s bailout terms—don’t require any dividend payments to be made when Fannie and Freddie lose money.

Projections from the Treasury show that as of August 2012, Fannie would exhaust the $125 billion in remaining government support by 2024 simply to make the dividend payments. The mere threat of receivership would have spooked bond investors long before that date was reached.

The government wasn’t alone in this view. Several Wall Street research reports in 2012 had raised similar concerns, in part because the dividend payments—almost $12 billion a year for Fannie and $7 billion a year for Freddie—exceeded the firms’ annual profits for most of their corporate lives. In an interview one week before the government amended the bailout, Fannie’s then-CFO, Susan McFarland, told the Journal that it was “hard for me to envision” that the company would “make enough every single quarter to cover the dividend payment.”

Of course, those fears turned out to be wrong. Rising home prices fueled huge profits at Fannie and Freddie last year of $84 billion and $48.7 billion, respectively.

This brings us back to Mr. Berkowitz’s latest argument. Even if the government’s projections hadn’t proven way off the mark, he says that the government’s initial 2008 backstops of the companies allowed for them to avoid paying the 10% cash dividend, and instead to pay a 12% stock dividend. Under that scenario, the government wouldn’t collect any cash, but it would increase its stake in Fannie or Freddie by a larger amount. (This Congressional Research Service report offers more background on the setup.)

Spokesmen for Freddie Mac, the Treasury Department and the Federal Housing Finance Agency, the firms’ regulator, declined to comment. Philip Laskawy, Fannie’s nonexecutive chairman, said in a statement last week that the FHFA had sole authority to decide how dividend payments were made.

In Fairholme’s view, if Fannie or Freddie stopped paying cash dividends, then the companies wouldn’t have faced any prospect of exhausting their Treasury support because they wouldn’t have had to take Treasury funds, which were finite, to pay the government the required dividends.

“The rationale that’s been given for the third amendment is total nonsense,” said Mr. Berkowitz. Either the government, together with the companies, weren’t aware of the non-cash alternative or “there’s some Machiavellian something going on,” he added. “I prefer the simpler reason that no one bothered to read the agreement.”

A third possibility is that Fairholme’s reading of the documents is different from the government’s, just as Fairholme’s argument that Fannie and Freddie should be run for private shareholders is at odds with the government’s view that, under federal law, the rights and powers of the companies transferred to the FHFA when the firms were placed into conservatorship.

Some officials may have viewed the non-cash dividend payment as a last resort, something to be exercised only in the event that the companies could not come up with the cash. The government’s stock certificate covering their investments in Fannie and Freddie say the non-cash payment would be exercised only in the event that the companies “failed to pay dividends in a timely manner as required by this certificate.”

Ultimately, the question is likely to end up before a judge. A separate lawsuit filed in federal court in Iowa last month by Continental Western Insurance Co., another Fannie and Freddie shareholder, raised the same argument put forward by Mr. Berkowitz. It argues that the companies weren’t required to pay cash dividends. Continental Western is being represented by Cooper & Kirk PLLC, which is also representing Fairholme in its lawsuit before the U.S. Court of Claims.

“The wording can be interpreted in different ways that people who drew up the document didn’t expect,” said David Felt, a lawyer in private practice who headed litigation for the FHFA until 2010.

“I can’t say that the Fairholme interpretation is wrong,” he added. “But even if you view [non-cash payments] as an option, was there a reason for paying a 10% dividend versus a 12% non-cash dividend? It’s pretty obvious that there is because one is cheaper.” Mr. Felt is informally advising some shareholders but isn’t involved in the Fairholme litigation.