Wall Street’s Romance With Fan & Fred

Nov. 29, 2013 6:54 p.m. ET

Astonishingly, certain big-name investors don’t take the federal government very seriously. Activists like Bill Ackman continue to fascinate the media but few have noticed that Fannie Mae and Freddie Mac are the biggest activist projects going right now, with investors maneuvering to profit from shares that Washington repeatedly has insisted will end up worthless.

Mr. Ackman, famous for his Herbalife and JCPenney jousts, is the latest to join, buying nearly 10% of Fannie and Freddie’s publicly available shares, in a scramble that also includes Richard Perry of Perry Capital, Bruce Berkowitz of Fairholme Capital and several others. Mr. Ackman, in a statement issued by his Pershing Square Capital, grandly declares his readiness to “engage in discussions with management, the board, other stockholders of the issuer, representatives of the federal government, and other relevant parties.”

Four reasons seem to explain why these superinvestors believe both political parties are blowing smoke when they claim they intend to put Fannie and Freddie out of business.

Firstly, it’s just politics. Fannie and Freddie are toxic politically, so the political incentive is to talk up their demise. That doesn’t mean the political incentive is to follow through.

Secondly, Fannie and Freddie are one of the few things holding up the mortgage market. Privatizing their functions, which politicians claim to favor, would lead to a tightening of lending standards, which politicians surely don’t favor.

Thirdly, Fannie and Freddie have become insanely profitable.

Even so, what makes private investors think they would ever be allowed to share again in the profits now flowing in profusion to the government? This brings us to the fourth reason: a lawsuit.

When the federal government took Fannie and Freddie into what it called conservatorship in 2008, it allowed 20.1% of their common shares to remain with private shareholders for reasons that were never explained. A likely motive is that, under accounting rules, the federal government would have been obliged to add Fannie and Freddie’s $5 trillion in outstanding debt overnight to the federal government’s then-debt of $10 trillion, which would have been politically explosive even if meaningless in economic terms.

Understand: The legal claim that some investors, including Mr. Perry and Mr. Berkowitz, already are asserting in court doesn’t concern the 2008 takeover itself but a subsequent move by Treasury on Friday, Aug. 17, 2012.

On its own whim, Treasury decided that Treasury would be entitled to 100% of Fannie and Freddie profits despite owning less than 80% of the stock. This decision undoubtedly came because Treasury could see that Fannie and Freddie were turning a corner and, in the distorted postcrisis mortgage market, were about to start accruing huge profits.

Yet the decision was never justified in light of the deal that left a 20.1% stake in the hands of private holders, presumably in return for some unstated benefit.

Legal beagles are divided on the merits of any claim. For a happy precedent, some hark to the famous Constitutional “takings” victories after the 1980s thrift crisis. The Supreme Court ultimately authorized billions in compensation for the benefit of private investors who were similarly manhandled once they’d served Washington’s purpose in the S&L bailout.

More important, the hedgies buy themselves a seat at the table. They are speculators in the least unflattering sense. They’ve put down a gutsy bet on their ability to maneuver, lobby and litigate in a situation of extraordinary complexity and uncertainty, hoping to extract something of value at the end of the day.

Our own guess is that, all things considered, the path of least resistance is some restoration of Fannie and Freddie to their pre-crisis form (as regrettable as that would be), which could pay off nicely.

Mr. Berkowitz of Fairholme has drawn up the most explicit proposal. Fannie and Freddie’s existing portfolio and related liabilities would remain with existing common shareholders and the government. Their mortgage-insurance businesses would be recapitalized as two new companies in the hands of preferred shareholders. These firms would carry on as purely private operations without any implicit federal guarantee.

The latter part is a joke, of course. The federal government has been utterly unable to figure out how to stop providing implicit guarantees to “too big to fail” financial institutions, which the new Fannie and Freddie would certainly continue to be.

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