Investors in America’s housing-finance giants lose in court

ONE unresolved issue from the financial crisis is the future of Fannie Mae and Freddie Mac, the two firms that stand behind much of America’s housing market. Fannie and Freddie purchase mortgages, bundle them into securities and sell them on to investors with a guarantee. When America’s housing market collapsed a decade ago, the government had to bail them out. Its treatment of the firms since then has created a titanic legal struggle. Shareholders have cried foul. On February 21st, a federal appeals court upheld a ruling in the government’s favour.

At issue is the Obama administration’s decision in 2012 to hoover up all of Fannie and Freddie’s profits. Until then, it had received a fixed dividend on its investment. The timing of the shift was striking—just before a surge in the firms’ profitability. Since 2008 the Treasury has sucked in about $250bn from the firms, 30% more than the cost of the bail-out.

The change enraged hedge funds who had bought Fannie and Freddie’s shares and found themselves expropriated. The investors’ lawsuit held that the government overstepped its authority by seizing all profits. A federal court dismissed that claim in 2014; it has taken until now for an appeals court to uphold the most important parts of the decision. An odd aspect of the ruling is that it largely ignored the substantive arguments but concluded the court lacked the authority to curb the government’s actions.

Its ruling sent shares in Fannie and Freddie tumbling (see chart). That reversed about half of the rally sparked by Donald Trump’s victory in the presidential election. Investors reckon that Mr Trump’s administration will be more favourable to Fannie and Freddie’s investors. Initially Steve Mnuchin, now treasury secretary, told a business-news network that Fannie and Freddie should be privatised again. But in his confirmation hearing before the Senate in January, he seemed to roll back those remarks.

The firms are hardly robust. The Treasury is running down their capital by $600m a year. By 2018 they will have none left. From then on, should the firms make a loss, they will need to draw on an emergency line of credit from the government. Doing so would be characterised by some as a second bail-out.

That worrying prospect should provide some impetus to the search for an alternative solution. But it will be hard to find an ownership structure for Fannie and Freddie that satisfies everyone. The firms keep mortgages cheap by lumping taxpayers with a staggering amount of risk. (If the housing market collapsed, the cost to the Treasury could be 2-4% of GDP, according to an analysis by The Economist). Few will want investors to make profits on the back of such a taxpayer guarantee.

The court did allow the plaintiffs to litigate some contractual claims. And one of the three judges in this court dissented starkly from the ruling. The government, she noted, had “pole-vaulted” over its authority. The plaintiffs were “not all innocent or ill-informed investors”. But they had been betting the rule of law would prevail: “In this country, everyone is entitled to win that bet.”