Taxpayers on Hook for Mortgage Executives’ Legal Defense Costs

When the U.S. government took over mortgage giants Fannie Mae and Freddie Mac, taxpayers inherited more than just bad debts. They’re also potentially on the hook for tens of millions of dollars in legal fees for the executives at the center of the housing market’s collapse.

With the Justice Department investigating companies involved in the mortgage and financial meltdown, executives around the country are hiring defense lawyers. Like many large companies, Fannie and Freddie had contracts promising to cover legal bills for their executives.

When the Treasury Department delivered a $200 billion bailout to Fannie and Freddie, that obligation passed to the government, which may find itself paying for the lawyers defending the executives against the government’s own prosecutors.

“Who’d have thought we might be on the hook for paying the defense costs when we’re also paying the prosecution costs?” said Doug Heller, executive director of Consumer Watchdog, a Santa Monica, Calif.-based group that has been critical of the financial bailout packages. “To defend the economy from the havoc that’s been created, we’re going to defend the havoc creators?”

The Bush administration is working to avoid it. The Federal Housing Finance Agency, which controls Fannie and Freddie, said in regulatory filings it soon will try to prohibit the two companies from paying legal fees to their executives. But such a prohibition almost certainly would lead to a costly court fight over who’s responsible for the bills when the Justice Department comes knocking.

Fannie’s and Freddie’s contracts also cover legal fees from shareholder lawsuits. Taxpayers could be forced to pay those legal bills, too. If the shareholders win — if they can prove the companies were mismanaged — the government could be liable for millions of dollars to make up for the executives’ failures.

It wouldn’t be the first time federal money intended to prop up the financial industry was used for unintended purposes. Days after it received an $85 billion federal bailout loan, the huge insurer American International Group Inc. spent $440,000 on an executive retreat with spa treatments, banquets and golf outings.

Both Fannie Mae and Freddie Mac have been subpoenaed as part of the wide-ranging Justice Department investigation into the companies’ accounting, disclosure and governance practices. The two companies are key to the U.S. mortgage industry. After banks make loans to home buyers, Fannie and Freddie buy the mortgages from the banks so bankers can have cash on hand to make more loans and keep the economy humming. Fannie and Freddie then bundle those loans and sell them as mortgage-backed securities. The proceeds of those sales help buy more mortgages.

In recent years, however, the companies purchased more risky, subprime mortgages. When the housing bubble burst and the subprime industry imploded, investors feared the risk of buying Fannie and Freddie’s mortgage-backed securities, making it harder for the companies to raise money.

Combined, Fannie and Freddie own or guarantee nearly half of all U.S. mortgages. The Treasury Department stepped in to keep the companies from collapsing and taking the mortgage industry with them.

Neither Fannie nor Freddie has said whether they already have advanced any legal fees to former executives. The companies are required to make general disclosures about such payments but only on quarterly corporate filings.

When the government took over, Fannie Mae chief executive Daniel H. Mudd, Freddie Mac chief executive Richard F. Syron and the rest of the companies’ leaders were dismissed. All those executives would be entitled to have their legal fees covered.

The obligations could easily stretch into millions of dollars. Both companies have promised to pay legal fees for all current and former board members, executives and employees charged or investigated in connection with their employment.

Legal fees can add up quickly. After Freddie Mac restated its earnings in 2003, it became embroiled in several investigations and lawsuits. By the middle of 2005, the company had paid $16.8 million in legal fees for its executives and employees.

Executives who are convicted of wrongdoing are required to give the money back. Those who are acquitted, who are merely witnesses or who are investigated but never charged do not need to reimburse the company.

It’s impossible to determine how much money might be at stake. In taking over the two mortgage giants, the government pledged to spend up to $200 billion to keep both companies afloat. The amount the government actually will spend depends on how well the companies perform in a changing mortgage industry.

With so much money at stake, defense attorneys are watching closely to see how broadly housing regulators restrict any future legal payments. The Fannie and Freddie contracts give the executives the right to sue to force the companies to pay their legal fees. If the executives win, the cost of those lawsuits gets passed to Fannie and Freddie, and potentially to the taxpayers.