Fannie Mae and Freddie Mac shareholders sued the U.S., alleging that the 2008 takeover of the housing lending giants was illegal and cost investors billions of dollars.

The takeover of the mortgage companies by the Federal Housing Finance Agency, "while beneficial to the economic welfare of the nation, destroyed the value of Fannie Mae's and Freddie Mac's common and preferred stock and trampled the private ownership rights" of shareholders, according to the complaint filed yesterday in the U.S. Court of Federal Claims in Washington.

The shareholders' complaint seeking $41 billion in damages was filed by the Seattle-based law firm Hagens Berman Sobol Shapiro LLP, a lead counsel in class-action lawsuits including those against Toyota Motor Corp. (7203) over the unexpected sudden acceleration of vehicles.

Investors in Fannie Mae (FNMA) and Freddie Mac have taken a renewed interest in the companies' future now that they have started posting record profits as the housing market rebounds. Fannie Mae had its best year ever in 2012, reporting net income of $17.2 billion for 2012, outpacing S&P 500 companies such as Wal-Mart Stores Inc. (WMT), General Electric Co. (GE) and Berkshire Hathaway Inc. (BRK/A), according to data compiled by Bloomberg.

Freddie Mac, the smaller of the two, reported earning $11 billion last year. Both have said they expect to remain profitable.

Investors are speculating that the companies might repay their debt to taxpayers and exit government control. In the past three months, investors have bid up the companies' common stock eightfold to a recent peak of more than $5.

Preferred shares have more than tripled, rising to more than $8. Fannie Mae's common shares fell 3.5 percent to $1.91 yesterday. Preferred shares closed at $7.55.

The U.S. Treasury Department determined the terms of the government's financial agreements with Fannie Mae and Freddie Mac. Anthony Coley, a Treasury spokesman, didn't immediately respond to an e-mail after regular business hours yesterday seeking comment on the lawsuit.

The two companies, which package mortgages into securities on which they guarantee payments of principal and interest, were seized by regulators as they neared bankruptcy. They drew $187.5 billion in taxpayer aid to stay afloat.

"The government bullied and coerced the companies' boards of directors" into consenting to the takeover at the expense of property rights, according to the complaint.

"The companies' willingness to continue providing liquidity to the mortgage markets on a large scale was crucial to the recovery of the devastated home market and the broader economy," lawyers for the plaintiffs wrote. "The government took control of the companies to make sure this happened on its terms, completely ignoring the loss of rights and economic value it caused to the shareholders."

Leading up the government takeover, Fannie Mae's and Freddie Mac (FMCC)'s "financial status did not warrant the imposition of conservatorships," the shareholders said in their complaint. They argue that neither company satisfied any of 12 financial and other criteria for a takeover outlined in the Housing and Economic Recovery Act of 2008.

The government forced Fannie Mae and Freddie Mac to delist their shares, terminate shareholder meetings, assume additional subprime assets and "accept tens of billions of dollars from the Treasury," according to the complaint. "In exchange, the companies were forced to grant the Treasury unprecedented and usurious cumulative dividends of 10 percent to 12 percent."

Now that the firms are profitable, "it's reasonable to expect" there will be more lawsuits like this, said Tim Rood, a former Fannie Mae executive who is now a managing director at Collingwood Group LLC, a financial services consulting firm based in Washington.

The government "conservatorship is really the most unprecedented of unprecedented takeover events," Rood said in a phone interview.

"It becomes increasingly difficult and indefensible to reconcile the fact that they have claims on all of the profits but don't take any of the liabilities on balance sheet," Rood said.

Under the terms of the conservatorship agreement, the liabilities of the two companies don't appear on the government's balance sheet.

There is no provision for Fannie Mae or Freddie Mac to exit conservatorship under their current agreement with the Treasury.

Instead, the government takes all of their quarterly profits, which count as a return on the U.S. investment in the firms, and not as repayment of their debt.

That arrangement forces "Fannie Mae and Freddie Mac to completely and fully transfer any remaining economic value from their shareholders to the Treasury, guaranteeing that the shareholders are left with nothing," according to the complaint.

The damages sought in the lawsuit were calculated by measuring the difference in the value of the companies' preferred and common shares between Friday, Sept. 5, 2008, and the following Monday, the first day of trading after the government takeover.

Those differences totaled more than $25.9 billion for Fannie Mae and more than $15.6 billion for Freddie Mac, according to the complaint.

Hedge funds including Paulson & Co. and Perry Capital, which have invested in the preferred shares, have been lobbying Congress to consider allowing Fannie Mae and Freddie Mac to become independent again. Republican and Democratic lawmakers and President Barack Obama have called for both companies to be liquidated.

"It's probably dawning on some of these investors that the political branches of government aren't going to provide them with any relief," said Jeb Mason, a partner at The Cypress Group, an investment consulting and research firm based in Washington. "The courts are sort of left as the one potential avenue for success."

Plaintiffs in the case include Washington Federal (WAFD), a Seattle bank, the city of Austin, Texas, Police Retirement System and Michael McCredy Baker, who is identified as an individual shareholder.

Sampson Jordan, the chief executive officer for Austin's $552 million Police Retirement System, didn't immediately return a call yesterday seeking a comment on the complaint.

The case is Washington Federal v. U.S., 13-cv-00385, U.S. Court of Federal Claims (Washington).


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