https://www.law360.com/articles/1542645
Jury Told Fannie, Freddie Profit Sweep Was ‘Unprecedented’
By Katie BuehlerLaw360 (October 24, 2022, 8:09 PM EDT) — A financial expert told a D.C. federal jury on Monday that the Federal Housing Finance Agency‘s decision to amend stock purchase agreements and allow the U.S. Treasury to sweep up Fannie Mae’s and Freddie Mac’s net worths was “totally unprecedented” and unnecessary.
Bala Dharan, managing director of corporate finance consulting group Berkeley Research Group LLC, said public filings, internal documents and internal communications show it wasn’t reasonably necessary for the FHFA 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.
Shareholders of the companies allege the 2012 amendments, also known as the “net worth sweep,” improperly increased the department’s dividend from 10% of its total investment to 100% of the companies’ current and future net worths.
The FHFA also capped the amount of capital Fannie Mae and Freddie Mac could reserve at $3 billion each in 2012 — a maximum amount that decreased every year by $600 million in an effort to shrink the companies and decrease the federal government’s involvement in the secondary housing market.
“Both of these provisions are just totally unprecedented,” said Dharan, who teaches accounting and finance at Harvard University and the Massachusetts Institute of Technology.
He added he’d never seen a net worth sweep instituted in his more than 40-year career until this case.
Three classes of Fannie Mae and Freddie Mac shareholders are seeking $1.6 billion in damages from the FHFA, the government conservator of the companies, for allegedly breaching the implied covenant of good faith and fair dealing in connection to the 2012 amendments. They claim the changes 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.
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 10% dividend set out in the original deal.
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 market crash.
But Dharan testified Monday the FHFA knew from internal data and projections that the circular draw wouldn’t be an issue in 2012 or the future.
Before the net worth sweep was implemented, Fannie Mae was projecting it would need just $6.5 billion of the remaining $124.8 billion in Treasury funding available to stay afloat between 2012 and 2022. Freddie Mac had estimated it would need no further funding in that same period, despite having $148.3 billion available.
“I just don’t see how [the] net worth sweep can be justified when you have this type of projection,” Dharan said.
The companies were also expected to increase their net worth significantly by writing up their deferred tax assessments, or tax credits awarded to companies in years when they owe no taxes that can be used to reduce the amount of taxes paid in future years. Fannie Mae and Freddie Mac had about $100 billion in combined deferred tax assets that would be reinstated on their balance sheets as the companies started seeing profits again.
Despite knowing all of this information by mid-2012, the FHFA still agreed in August 2012 to the amendments allowing the net worth sweep, Dharan said.
During cross-examination, an attorney for the FHFA, David Bergman of Arnold & Porter, attempted to undercut Dharan’s testimony by pointing out that the projections the expert relied on were draft projections that differed from their final versions.
Specifically, the draft projections estimated Freddie Mac’s net worth would be $25.2 billion in 2022 when the final projections estimated only a $6.3 billion net worth for the company.
Dharan countered that he didn’t rely on the projected net worths in his analysis, but on the estimated total Treasury funding that would be used by the companies by 2022, which stayed relatively the same between the draft and final versions.
Bergman also noted that the projections used by Dharan were 10-year projections, which Fannie Mae and Freddie Mac didn’t usually develop. The companies usually only estimated the next three or five years, he said.
Dharan said he used the draft projections as an example of what the FHFA knew before agreeing to the net worth sweep, and that he hadn’t seen anything to say they were completely off.
The expert added his analysis showed the FHFA didn’t study other options to the net worth sweep, something then-FHFA acting Director Edward DeMarco has already admitted to. DeMarco told the jury last week the FHFA didn’t analyze the net worth sweep before agreeing to it either.
The former head of the FHFA’s financial modeling division corroborated that in a video deposition shown to the jury Friday. She said her division was never asked to produce any reports about the net worth sweep and that she only learned of it the day it was publicly announced.
But, she added she could understand the reason for it because the companies had previously stated in filings with the U.S. Securities and Exchange Commission that they might have problems paying the 10% dividend despite being profitable in 2012 and beyond. She said the net worth sweep would address that issue.
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 the 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. The Treasury was also on track to capturing 80% of the companies’ profits going forward under the stock purchase agreements.
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 in-kind investment increases.
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 & Grossman 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.
The Federal National Mortgage Association, or Fannie Mae, is represented by Meaghan VerGow of O’Melveny & Myers LLP.
The Federal Home Loan Mortgage Corp., or 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.