Fannie Mae and Freddie Mac shares jumped more than 20% during morning trading on Sept. 9 after a key court ruling potentially cleared the path to recapitalizing the companies.
The Fifth Circuit Court of Appeals in New Orleans on Sept. 6 partially reversed a lower court's decision in the shareholder case against the U.S. Treasury Department. The appeals court appeared to agree with investors that the Federal Housing Finance Agency had overstepped its authority when it agreed to amend its preferred stock purchase agreement with Treasury, signed in September 2008 as the government-sponsored enterprises teetered on the edge of collapse. The ruling could be the first step in allowing Fannie Mae and Freddie Mac to build the capital reserves needed to exit conservatorship, which could be a boon for shareholders.
Compass Point Research & Trading LLC analysts upgraded the stocks for both Fannie Mae and Freddie Mac in a Sept. 9 note on the news, setting price targets of $7.75 per share for Fannie Mae and $7.00 per share for Freddie Mac. As of 12:20 p.m. ET on Sept. 9, Fannie Mae's stock was up about 27% at $3.44 per share, and Freddie Mac's stock was about 27% higher at $3.25 per share.
The preferred stock agreement from 2008 provided Treasury with 1 million senior preferred shares in the GSEs in exchange for a capital commitment from Treasury. Those preferred shares entitled Treasury to quarterly dividends, stock warrants and other rights. As the financial crisis persisted and the GSEs continued to need additional capital, the agreement was amended multiple times. The third amendment eliminated a 10% dividend, which the GSEs lacked the cash to pay, and replaced it with variable dividends equal to the GSEs' net worth except for a capital reserve.
Investors dubbed the amendment a "net worth sweep" and have alleged it has precluded the GSEs from recapitalizing, a step they see as necessary to exiting conservatorship.
In the years since the crisis, those dividends have totaled more than what the GSEs received from Treasury. The court filing indicates Treasury has disbursed $187 billion to the GSEs and has recouped $250 billion.
"The Shareholders plausibly allege that the Third Amendment exceeded FHFA's conservator powers by transferring Fannie and Freddie's future value to a single shareholder, Treasury," the ruling stated.
In the 9-7 opinion, the judges "lambasted" the net worth sweep, wrote the Compass Point analysts. However, the analysts noted that the judges stopped short of invalidating the net worth sweep, instead remanding the case back to a lower court. However, considering the appeals court's "detailed reasoning," the analysts wrote that "shareholders appear relatively well-positioned" to win at the district court level.
In a separate opinion, the appeals court also agreed with shareholders that the FHFA was unconstitutionally structured since it has a single director that can only be removed for cause. That opinion could give the FHFA and Treasury a sense of urgency to resolve the GSEs' situation before the 2020 presidential election, after which the FHFA's director could be removed should Democrats win the White House, Compass Point analysts wrote.
