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GSE Shareholder Fairholme Describes Maximum Delay Discovery Rigmarole

Fairholme is trying to get the government to produce documents that the government doesn’t want to produce and a judge in the court of claims ordered to be produced.

The government appealed the judges order and Fairholme filed their response in support of Judge Sweeney’s order suggesting the government’s approach is one of maximum delay.

Fairholme openly wonders what the purpose is of discovery if one party can simply assert privilege over documents where privilege simply does not apply to prevent from handing them over.

Something wild has happened and there’s nothing you can do about what’s happened, but you can still take action and share in what is going to happen. In unprecidented fashion, Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) were placed into conservatorship in 2008 when they had their highest levels of capital in history. Their entrance into conservatorship was not due to a liquidity crisis but was due to the board acquiescing when government employees asserted authority. Since then, they’ve continued to generate large amounts of cash in spite of their conservator justifying their conservatorship by forcing them to write down their assets to issue a related party stock.

The government, although it is taking the net worth of the companies, has not consolidated them onto its balance sheet because of private shareholders like myself continuing to own some of the publicly traded shares that are economically worthless as long as the government takes the net worth. You might be thinking to yourself that this sounds a lot like accounting fraud and indeed the smaller accounting fraud lawsuit was just settled out of court. The larger of the two remains active. The problem with Fannie and Freddie is that they make money so consistently that the government has budgeted their income as its own and has increased their fees to consumers for itself since conservatorship has begun. We have seen the actual government bailouts, where companies weren’t as good. Those were not worth keeping control over and spun back into the private markets. The main reason to invest in Fannie Mae and Freddie Mac is the same reason that the government is zeroing them out in the first place: they make too much money too consistently. Conservatorship hasn’t changed this fact and instead has drawn increasing scrutiny to it especially since the accounting trickery has been placed into the rear view mirror.

Investment Thesis: Lawsuits have been filed against various actions taken against Fannie Mae and Freddie Mac by their shareholders and if any of these puts an end to the net worth sweep or results in other shareholder positive events then shareholders stand to benefit. Reversing the net worth sweep could result in Fannie Mae and Freddie Mac eventually returning to business as usual which would eventually make their preferred shares worth par. Their common shares used to trade over $50. Part of their entrance into conservatorship was the government issuing to itself 79.9% warrant coverage. These warrants haven’t been exercised yet but I’m expecting something similar to AIG assuming the companies remain operational. Common shares trade at less than $2, leaving lots of potential upside on the table and preferred shares trade at less than 20% of par.

Court Of Appeals For The Federal Circuit

Fairholme filed their response to the government’s petition for a writ of mandamus:

We learn that plaintiffs plan to amend their complaint and that they are alleging that the government placed Fannie and Freddie into conservatorship even though an analysis of the companies’ financial statements shows that throughout the crisis their income, retain reserves, and unencumbered assets were always more than sufficient to cover their debts and other expenses. Plaintiffs highlight the questionable nature of the accounting policy decisions that resulted in massive temporary draws and reversals split by the implementation of a net worth sweep. Plaintiffs also show that the write offs were more aggressive at Fannie and Freddie than at other financial institutions that held far riskier portfolios.

Plaintiffs speak candidly about how the government has been improperly asserting privilege because when they question it, the government has a history of removing privilege designations from handfuls of the documents. Plaintiffs suggest that this is a strategy of maximum delay:

Plaintiffs show a need for these documents by demonstrating that Ugoletti’s sworn declaration was undermined by discovery which he later recanted.

Further, their intended purpose by filing discovery documents in multiple court rooms is simply to prevent the government from asserting untrue facts in other courts:

Plaintiffs go through the way a Writ is supposed to work and show that the government is misconstruing what they are for:

Plaintiffs openly wonder why the government references materials from the agency who they are claiming isn’t in charge:

Plaintiffs conclude by openly wondering that if disclosure is not supported here then where?:

It would seem that Judge Sweeney ruled favorably for Plaintiffs and rather than complying with discovery, the government decided to file a Writ to buy time while Perry Capital was ruled. Plaintiffs are looking for discovery to be completed before they amend their case and they claim that the government’s history of not been forthcoming with documents as evidence that this is simply more of the same.

Summary and Conclusion

The government doesn’t want to produce documents that they have marked as privilege. Judge Sweeney ordered the government to hand them over saying that of a sample that plaintiffs claim is effectively random 100% were improperly designated as privileged. Further, Judge Sweeney ordered the government to explain why they shouldn’t have to pay plaintiff legal expenses for making plaintiffs file the motion to compel. The government responded by appealing Judge Sweeney’s motion to compel. The government says that in effect, Judge Sweeney doesn’t understand the discovery process or how privilege designations work.

According to Plaintiffs, the government’s understanding behind what a Writ of Mandamus is for is being improperly applied in this case. If you study the accounting statements, the government has taken over $100B of cash out of Fannie Mae and Freddie Mac since conservatorship has begun. The government has done so by writing down assets and later writing them back up. The neat trick was that between the two events the government entered into the net worth sweep, thereby zeroing out existing shareholders.

I think that FHFA has fiduciary duties that it simply has chosen to ignore. There is no other explanation for why the shares remained outstanding in 2008. FHFA’s argument is that the shareholders that own these shares have no legal right to breach of contract claims, among others. If true, why did PricewaterhouseCoopers settle with a handful of such shareholders? Perhaps PricewaterhouseCoopers didn’t believe FHFA’s arguments as much as FHFA does. I don’t either.

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