On Oct. 1, shares of Fannie Mae (FNMA 1.37%) and Freddie Mac (FMCC 1.10%) plunged on the news that a U.S. district court judge threw out several investor lawsuits attempting to force the government to share some of the agencies' profits.
Since then, shares have rebounded considerably, with Fannie Mae's and Freddie Mac's common stock up by more than 50% and 40%, respectively, since bottoming the day after the announcement.
Has anything really changed? Are shareholders more hopeful now? And what are the power-players doing to fight the ruling?
A brief history of the Fannie and Freddie legal battle
Simply put, shareholders are upset that 100% of the profits of both Fannie and Freddie are automatically sent to the Treasury as "dividend payments." The government is getting an excellent return on its investment, and the total dividends paid so far have actually added up to about $30 billion more than the agencies received in the bailout.
However, the profits are considered dividends, not repayment, so the Treasury will receive a stream of profits from Fannie and Freddie indefinitely. And the agencies will still owe the full amount of the bailouts received.
Naturally, this seems very unfair to shareholders. After all, they took a chance by investing in the agencies while they appeared to be down and out. Now that they're profitable again, doesn't it make sense that shareholders should see some returns?
Well, although most experts seem to agree that the shareholders are getting a raw deal here, that doesn't necessarily mean it's illegal. And that's exactly why the judge ruled against the shareholders. He found that the Housing and Economic Recovery act does indeed give the FHFA the power to take the agencies' profits.
The dismissal covered at least 10 separate lawsuits, and it's important to note that some of the most high-profile lawsuits are still outstanding, such as the one filed by Pershing Square, the largest shareholder of both agencies.
Recent developments
There have been two major developments lately that have helped boost investor confidence in Fannie and Freddie.
First, fund managers Richard Perry and Bruce Berkowitz, who are the two most prominent investors whose lawsuits were dismissed, plan to appeal the judge's ruling. In a letter issued to shareholders, Berkowitz said, "[T]he D.C. District Court judge is either wrong or the law is unconstitutional." And Perry Capital filed an appeal just days after the judge's dismissal.
Also, it is more significant to investor confidence when the major players are willing to throw their own money behind investments when they're beaten down, and Pershing Square's Bill Ackman did just that. About a week after the dismissal, it was reported that Ackman added to his common stock holdings in both agencies in the wake of the judge's ruling.
And, while it's uncertain just how much of the agencies' common stock Pershing Square holds now, it was reported earlier this year that the fund owned a 10% stake in both. So, the biggest shareholder in Fannie and Freddie just got even bigger.
Is there any chance to profit here?
Despite the recent appeals and confidence boost, nothing has fundamentally changed. The chances of a favorable outcome for shareholders are just as good (or bad) as they were immediately after the judge dismissed the lawsuits. So I have to think that the recent rally is a little bit overdone.
There is no reason to believe that the judge who handles the appeal will have any difference of opinion when interpreting the FHFA's authority. And the fact that a hedge fund bought more common shares has no affect whatsoever on the chances of success.
While it is definitely true that investors could make a ton of money if the lawsuits work out in the shareholders' favor, it's still a slim chance at best.
Just realize that when you buy shares of Fannie or Freddie that you're taking a gamble. The odds are definitely not in your favor, and they are nothing close to what I would refer to as "investments".
