More Stand to Win in AIG Case than Just Hank Greenberg

If former long-time AIG CEO Hank Greenberg prevails in his case against the federal government over the legality of the financial-crisis bailout of insurer American International Group (NYSE:AIG), he and his fellow shareholders might not be alone in recouping some of the winnings.

Many recent investors in mortgage lenders Fannie Mae (TICKER:FNMA) and Freddie Mac (TICKER:FMCC) are betting that they too might come out on top -- and as the FOX Business Network has reported -- they’ve been snapping up shares of both companies' stock in something known as “The Greenberg Trade.”

Shares of Fannie and Freddie surged more than 20% in heavy volume after FBN reported some traders are diving into both stocks betting that a Greenberg victory will be a victory for shareholders of the mortgage giants.

The trade’s thesis goes something like this: Both Fannie and Freddie continue to send money to the federal government, even after repaying the $188 billion bailout funding from the financial crisis. It's a move several shareholders say is illegal, and have sued the government arguing that all the bailout profits should go back to shareholders.

Greenberg is also suing the government on similar grounds. He contends that the government’s 2008 AIG bailout represents an illegal “taking” of shareholder property because under the terms of the deal, the government financing diluted or reduced in value of existing investors in the stock, and ignored less onerous private sector alternatives. Greenberg was ousted in 2005 over unrelated regulatory issues, and was once company’s largest shareholder.

In other words, if Greenberg can prove the government illegally diluted his stake in AIG, why can’t shareholders of Fannie and Freddie make the same case? And with shares of both mortgage lenders trading at penny-stock levels (below $5) isn’t now the time to buy the companies' shares, betting a Greenberg precedent will carry over to shareholders of the mortgage giants?

Of course, in order for the trade to work, Greenberg would have to prevail in Federal Claims court, where Judge Thomas Wheeler concluded the presentation of evidence and will hear oral arguments in March (he expected to rule in the Spring) But traders on Wall Street like what they’re seeing and hearing from the court so far. Greenberg has argued diluting shareholders was an arbitrary and illegal act by the government that wasn’t imposed on other recipients of the government 2008 bailout package, and ignored possible private-sector alternatives.

Testimony during the trial seemed to buttress this argument. Wheeler, meanwhile, has made several rulings in Greenberg’s favor and the case has withstood numerous attempts by the government to have it dismissed.

Wheeler also allowed the testimony of government officials in charge of the 2008 bailouts, such as former Federal Reserve Chairman Ben Bernanke, Treasury Secretary Hank Paulson and New York Fed Chief Tim Geithner. That testimony also appears to support Greenberg’s contention that the government’s approach to bailing out the insurance giant penalized its shareholders more than shareholders of the bailed out banks.

Legal experts say even if Greenberg prevails in court, that doesn’t necessarily mean it will create a precedent that could carry over to Fannie and Freddie shareholders.  But it should be noted that one of the shareholders suing the government over Fannie and Freddie, hedge fund manager Bill Ackman, has brought his case in Federal Claims court in Washington—the same court hearing the Greenberg case.

During an investment conference last week, Ackman called Fannie and Freddie “the most interesting risk-reward that I am aware of in the capital markets right now."

Based on the trading of Fannie and Freddie share, other investors appear to agree.