GSE’s Next Major Legal Development: Lamberth Ruling (OTCMKTS:FMCC)

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that are in conservatorship retaining earnings while the government puts all the pieces in place to restructure them as utilities and release them from conservatorship. The government currently has Senior preferred stock and warrants that basically lay siege to the capital structure preventing the companies from being able to do equity offerings to get out of conservatorship faster than just through retaining earnings alone.

The main shareholder brought legal challenge that I am following now is the DC District Lamberth breach of implied covenant of good faith. The purpose of this article is to outline the timeframe considerations for what I consider to be the next major legal development that I believe will lead to over a 100% price change in the preferred stock.

Investment Thesis

Last month, Sandra Thompson was sworn in as director of FHFA. Now, the Biden administration has all the pieces in place to move forward with monetizing its equity position in Fannie and Freddie and FHFA has completed all of the prerequisites for this. In the next three months, Lamberth is expected to rule on the government’s motion for summary judgement. The government’s motion largely prays that Lamberth reevaluates his earlier ruling against the government in light of the Supreme Court ruling in Collins v. Yellen.

The stock market at this point and its valuation of junior preferred stock seems to be apathetic at best. I expect that Lamberth rules against the government’s motion for summary judgment and that this ruling in the next three months immediately drives a re-evaluation of junior preferred upwards of 100% or more. It could serve as the catalyst that pushes the administration to come forward with a push to monetize its equity position if they haven’t already by that time.

Given the Supreme Court ruling on Collins v. Yellen, I see the courts blessing the liquidation preference of the Senior preferred stock and so I don’t see enough security in common shares in a restructuring for me to take a position there. The junior preferred, on the other hand, have contract rights that cannot be diluted and are scheduled to see a major game changing ruling around November or December of this year in the DC District court. In such an outcome, junior preferred could receive damages in addition to par value whereas the securities trade at 8-14% of par value.

Lamberth’s Original Scheduling Order

The government’s motion for summary judgment became fully briefed on May 6, 2022 and the trial was originally scheduled for July 11, 2022. The way trials work is usually judges are expected to rule on these motions before trial start. Since then, the trial has been rescheduled to start as soon as October. If Lamberth expected to rule in favor of the government’s motion for summary judgment, he could have done that without all of this rescheduling business.

Instead, a new trial date has been set and he has ordered the plaintiffs and the government to move forward with pre-trial work in anticipation of trial. This bodes well for plaintiffs as it implies that Lamberth is more likely than not to rule against the government’s motion to dismiss. Assuming he does, when that ruling comes out, it will be a sea change moment for the investing community who so far seems to just be under the predisposition that you cannot win legal challenges against the government having lost in the Appeals Court of Federal Claims and at the Supreme Court this past year on APA and takings claims.

Other Legal Paths To Resolution

To me, the contract claims lawsuit in the DC District presided over by Royce Lamberth is the big one because he has already ruled in favor of plaintiffs interpretation of the law on these claims and is heading to trial in October. That said, there are other lawsuits challenging government actions on constitutional grounds in Rop v. FHFA, Collins v. Yellen, and Bhatti v. FHFA. In addition, Fairholme v. United States is a takings case that will be filing its petition for review from the Supreme Court later this month.

The Case For Admin Action

The Biden administration has continued to let Fannie and Freddie retain earnings on their path out of conservatorship under the guidance of FHFA’s Sandra Thompson. If it wanted to, it could have changed course early on and drained them of their earnings and completely undoing the Trump plan to recapitalize and release Fannie and Freddie from conservatorship. Instead, the Biden administration put its twist on that plan and overall has maintained course towards recapitalization:

1. Capital Rule
2. Racial Equity
3. Capital Restoration Plans
4. Elimination of Adverse Market Fee
5. New Strategic Plan
6. Public Disclosure Requirements

The Supreme Court ruling has turned FHFA into a political agency. As such, should Biden want to preserve his view of housing finance reform he would need to lock it in before the end of his administration where the next president would instead run it how they see fit and possibly lock in their vision of housing reform instead.

Not only is there value in locking in one’s view of housing, but also there is $100B that can be unlocked and allocated in the process. This future state sounds much more attractive to me than the current state of things, where Biden pays tens of millions of dollars per year to fight shareholder lawsuits while flirting with the danger associated with having an undercapitalized housing finance system.

Summary and Conclusion

Lamberth had originally planned to rule on the government’s motion for summary judgment in the next two weeks but the trial has subsequently been rescheduled after the government’s motion for summary judgment became fully briefed. Lamberth has moved forward with scheduling the trial but has not yet ruled on the motion for summary judgment, which would be ruled against should the trial proceed.

The prevailing prices of junior preferred stock do not realistically anticipate this next Lamberth ruling going favorably for plaintiffs but this is in a case that has already had favorable rulings for plaintiffs and we should have this major legal ruling in the next three months. The junior preferred stock could trade from their current prices of 8-14% of par to north of 30% of par on a ruling against the government’s motion for summary judgment because it would mean that there is a judge who believes shareholders still have contract rights after the Supreme Court ruled that the government can do whatever it wants.

My view on that is that’s HERA. Sure, the government can do whatever it wants now that the Supreme Court has ruled that it can. That does not necessarily mean, however, that all the contract rights of stakeholders that do business with Fannie and Freddie are worthless. That’s what Lamberth is presiding over and I expect that his ruling on the government’s motion for summary judgment will cause investors to re-think their apathy towards these securities and to price them accordingly. The pretrial conference is set for September 19. We’re getting close.