The dysfunctional system of public risk and private profit that brought down Fannie Mae and Freddie Mac, at huge taxpayer expense, is dead and buried - unless, of course, a federal judge resurrects it for the benefit of a few lucky hedge funds.
Impossible, you say? Well, here's what's going on: Before the Great Recession, Fannie and Freddie were privately owned entities that guaranteed mortgage-backed securities. They were also "government-sponsored," a special status that conferred both a "public purpose" (fostering homeownership) and implicit federal backing for the risks they took to fulfill that role while making profits for their shareholders.
Fannie and Freddie failed when the economic downturn exposed their risk-taking as disastrously excessive. Their regulator, the Federal Housing Finance Agency, placed them in conservatorship in September 2008 and assumed operational control while the Treasury Department took 79.9 percent ownership - in return for an eventual $187 billion in taxpayer funds. The bailout was to be defrayed by an annual payment, conceptualized as a 10 percent dividend on the government's shares.
Private parties still owned 20.1 percent of Fannie and Freddie, but the companies' collapse reduced them to penny stocks, so nobody worried much about that.
By late 2012, Fannie and Freddie were headed back into the black, thanks to an improving housing market and higher securitization fees. Yet their final status remained unresolved amid the usual policy disagreements and partisan politics.
To protect taxpayers, and prevent a revival of the status quo, Treasury and the FHFA agreed to send all future Fannie and Freddie profits, not just a 10 percent dividend, to the Treasury. A month ago, the companies paid the Treasury a combined $66 billion, and, confounding many expectations, they are well on their way to repaying the entire bailout. Yet under the Treasury-FHFA deal, known for arcane reasons as the "third amendment," the government stake remains 79.9 percent, indefinitely.
Enter the hedge funds. Having bet that Fannie and Freddie would experience just such a turnaround - and, crucially, that it would take place before Congress figured out a permanent alternative to conservatorship - the hedgies had scooped up the forgotten 20.1 percent of Fannie and Freddie shares for practically nothing.
That stock would now be worth billions more if its owners could share in the entities' profitability; the hedge funds argue, accurately, that channeling all profits to the government amounts to a "cramdown" of private shareholders.
In their view, that's not only unfair but also against the law - specifically, the 2008 conservatorship statute, under which, they assert, the federal government's authority to change the "terms and conditions" of its ownership stake expired on Dec. 31, 2009. The 2012 "third amendment," they argue, used conservatorship to wind down the companies, which is only allowed in a different process, receivership, that FHFA opted not to invoke.
On July 7, the hedge funds filed their complaint in U.S. District Court, accompanied by a high-minded news release in which their attorney, Theodore Olson, fresh from his Supreme Court victory for gay marriage, declared that "this lawsuit seeks to uphold the rule of law."
And, of course, to make a killing. Nevertheless, the hedge funds' arguments are plausible - alarmingly so, I would say. The 2008 law does indeed say that Treasury's unrestricted authority to buy shares of Fannie or Freddie lapsed at the end of 2009.
Fortunately for the government, however, the same law specifically says that, once Treasury has bought shares, it can exercise its rights as a shareholder indefinitely.
So the case might hinge on this uncomfortably close question: whether the 2012 "sweep agreement" amounted to an additional government stock purchase, as the hedge funds contend, or whether it was merely an exercise of Treasury's existing ownership rights.
Morally, the government's case is a bit clearer. It takes chutzpah for the hedge funds to run crying to court about their role in the housing entities' recovery when taxpayers contributed far, far more. If not for the massive federal bailout, there wouldn't be any profit-making entities to argue about now.
As for the rule of law, property rights and the rest, I'm not sure what would be worse for the integrity of our loophole-ridden free-market system: brutally cramming down bottom-feeding hedge funds, or rewarding their relatively trivial investment with a gigantic taxpayer-enabled windfall.
One thing is certain: This is the sort of conundrum our society let itself in for by involving government so deeply, and so non-transparently, in the complex business of mortgage securitization.
Government should get out - and this wild card of a court case is one more reason to do so sooner rather than later.
Charles Lane writes for The Washington Post.