Todd T. Westhus is poised to join George Soros and John Paulson with an unlikely wager.

Soros broke the Bank of England in 1992 by betting on the devaluation of the British pound, netting $1 billion. Paulson took home $15 billion, anticipating the collapse of subprime debt that contributed to the financial crisis. Now, Westhus is trying to transform the $9.4 trillion U.S. mortgage market. The 38-year-old hedge fund partner was the mastermind of Perry Capital LLC’s 2010 purchase of Fannie Mae and Freddie Mac preferred shares at 2 cents on the dollar. Back then, the mortgage giants were just about given up for dead. Today, the companies are profitable and their shares have soared 24-fold.

Taxpayers rescued Fannie Mae and Freddie Mac in 2008 with a bailout that swelled to $187.5 billion, an amount the companies will finish sending back to the government this month. The issue for investors is that the Treasury Department decided in 2012 to keep all the companies’ profits. Perry sued the U.S. in July, saying the money sweep flouts the rule of law. Sen. Bob Corker, a member of the Senate Banking Committee, said the firms’ staunchest supporter should be rewarded.

The companies would “be generating not one dime of revenue if it weren’t for the federal government,” Corker, a Tennessee Republican, said in an interview.

Almost six years after bad home loans crippled the economy, Perry and other investment firms are battling a government that can’t agree on a fresh path forward. At stake is the future of housing, which contributed more than 15 percent of America’s economic activity last year, and the survival of Fannie Mae and Freddie Mac, which together guaranteed about 60 percent of new home loans in 2013.

Biggest Paydays

For the investors, it’s also one of the biggest potential paydays in history.

On the line is at least $33 billion in preferred shares, securities meant to be compensated before owners of common stock in the event of a bankruptcy. That’s an amount greater than the annual funding for the National Institutes of Health. The money could be fully repaid or wiped out, depending on the outcome of lawsuits and political jockeying.

There are greater rewards in the companies’ common shares. Fannie Mae’s stock has risen 1,800 percent since February 2013 and last week reached $5.45, the highest price since 2008. Bill Ackman of Pershing Square Capital Management LP said last month it could go up another 10-fold.

“It’s the biggest distressed trade in history,” said David Ford, co-founder of Latigo Partners LP, a $450 million event-driven credit hedge-fund firm based in New York. Ford first bought the preferred shares in 2011 when they traded at 4 cents on the dollar and started acquiring the common shares last year.

“We very much believe in the investment,” said Ford.

Fannie Mae, created by Congress during the Great Depression of the 1930s, and Freddie Mac, established in 1970 to compete with its older sister, keep money flowing through the U.S. home-loan machine by guaranteeing securities that lenders sell for the cash they can use to make more loans.

For decades, “the agencies” existed as hybrids, part publicly held companies, part extensions of government policy. They operated as private companies, selling shares to the public. Because investors believed they had the support of the U.S. government if they ever got into trouble, their borrowing costs were lower than those of other financial companies. After the companies nearly collapsed in September 2008 due to surging defaults of the mortgages they guaranteed, the implicit government support became explicit.

$500 Million

Perry, which manages $10 billion, now has about $500 million riding on the preferred shares, even after several rounds of sales, according to a person familiar with the investments. It also has a smaller stake in the common equity, the person said. Robert Terra, a spokesman for Perry at Hamilton Place Strategies, declined to comment and said its officials wouldn’t discuss the investment.

Fund managers who have invested in the preferred shares include Paulson, famous for his successful 2007 wager that U.S. subprime homeowners would quit paying their mortgages; Jeffrey Altman of Owl Creek Asset Management LP, one of last year’s best-performing hedge-fund firms; and Bruce Berkowitz, the slick-haired mutual-fund star who runs Fairholme Fund.

Units of private-equity firms Blackstone Group LP and Carlyle Group LP were invested in the shares last year, according to people with knowledge of their investments, while hedge fund Marathon Asset Management LP chief executive officer Bruce Richards said on Bloomberg Television last month that he sees betting on the companies as the best opportunity out there. Ackman’s Pershing Square and even Ralph Nader, the consumer activist and five-time U.S. presidential candidate, have said they own the firms’ even-riskier common shares.

Perry was ahead of the wave, thanks to Westhus. The hedge fund stuck to the trade even after rivals such as Kyle Bass of Dallas-based Hayman Capital Management LP said it was too risky to wager on government policy and sold his shares in 2012.

Westhus grew up in Massachusetts and competed on the Duke University swim team. He joined Perry in 2006 as an analyst from hedge fund Avenue Capital Group LLC, which invests in the debt of companies in trouble. He’d previously worked as a junior member of investment banking teams involved in company financing at Morgan Stanley and JPMorgan Chase & Co., according to a person familiar with his work history. He helped Perry profit by almost $2 billion betting against the performance of subprime home loans before the 2008 financial crisis.

Contrarian Strategy

Investments in Fannie Mae and Freddie Mac reflected the fund’s contrarian strategy. At the time, home-loan delinquencies had more than doubled, according to the Mortgage Bankers Association. Members of an investigatory panel created by Congress were discussing the companies only to argue about how much blame to assign them for the crisis.

Five months after Perry began buying Fannie Mae and Freddie Mac securities, Westhus visited a Treasury Department official to talk about the two companies, according to public records.

Fund founder Richard Perry, who has supported Democratic candidates, also met with policy makers to urge the survival of the mortgage companies, according to a person familiar with the discussions. Perry, who started the fund in 1988, is a Goldman Sachs Group Inc. alumnus and the nephew of former Bear Stearns Cos. chief executive officer Jimmy Cayne.

Perry brought on Julie Chon, a former senior policy adviser on the Senate Banking Committee, in 2012, who helped press Perry’s case in Washington. The firm failed to sway policymakers.

To take the case to court, Perry signed up former U.S. Solicitor General Theodore Olson, a partner at the Washington law firm Gibson Dunn & Crutcher LLP. Olson brought on Tony Fratto, a former spokesman for President George W. Bush, to spread the word about the merits of the case in the press.

The court clash between the U.S. and Perry, one of at least 18 legal skirmishes involving the two mortgage companies, is part of an effort that may determine how the country will finance home loans in the future.

The latest version of what might be called the Perry plan would start with the companies’ survival. Fannie Mae and Freddie Mac would keep profits rather than send them to the Treasury. It would also prohibit the companies from owning mortgages or bonds and create competition by setting up a common platform for turning home loans into securities, establishing an industry-funded reinsurer and raising the amount of capital the companies would be required to hold.

Berkowitz Proposal

Berkowitz proposed in November that his Fairholme Fund and other investors buy two businesses that insure mortgage-backed securities from Fannie Mae and Freddie Mac, in exchange for the preferred stock held by investors and at least $17.3 billion in new capital. In a Feb. 28 letters to the mortgage companies, he asked the boards of directors of the two companies to suspend payments to the Treasury until they “evaluate strategic and restructuring options” with the help of independent legal and financial advisers. Fairholme owns more than 20 million shares of common stock and more than 66 million of preferred shares.

Corker bristles at the idea that hedge funds will dictate government policy. He wrote legislation with Democratic Senator Mark Warner of Virginia that calls for the companies to go away. They’d be replaced by a new government-owned mortgage insurer modeled after the Federal Deposit Insurance Corp. It would charge for mortgage-backed securities guarantees that kick in after private capital absorbs the first 10 percent of losses. The heads of the Senate’s banking panel are working to turn the proposal into their own bill with input from the White House.

Policymakers from both political parties, including former Treasury Secretaries Lawrence Summers, a Democrat, and Henry Paulson, a Republican, join Corker in warning that fund managers may undercut efforts to do away with a duopoly that used an implied government guarantee to benefit private shareholders and is too big to be allowed to fail.

Reviving the companies is “just not, to me, what’s in the public interest, and people have hired me to look after the public interest,” Corker said.

Doing what’s right by shareholders, even by keeping the firms alive, won’t prevent lawmakers from overhauling the system, according to Matthew D. McGill, a partner at Gibson Dunn who’s working on Perry’s case.

‘Smoke Screen’

“People are using the political unpopularity of hedge funds to blow a smoke screen,” he said. “Congress could enact all kinds of laws to change the business models. It could change their names, it could change their ownership structure, it could remove their government charters, it could subject them to any matter of taxation. There’s all kinds of things that Congress could do on a going forward basis.” The money sweep, the focus of Perry’s legal complaint, “literally has nothing to do with that,” he said.

The conflict is playing out in public forums. Olson said last month at an event in Washington organized by Nader that the government was acting like Argentina, Russia or Cuba by stripping Perry and other investors of their money.

David Stevens, president of the Mortgage Bankers Association industry group who was Federal Housing Agency commissioner until 2011, derided investors pursuing their self-interest. The Federal Reserve’s policy of buying Fannie Mae and Freddie Mac mortgage securities to stimulate the economy has boosted their company profits, he said.

“The shareholders are all about the shareholders,” Stevens said. “Everybody else cares about getting the system right.”

The demands of hedge funds don’t need to disrupt the rebuilding of the system, according to Adam LaVier, a former Treasury official and now a managing director at Millstein & Co. LP, a financial advisory firm in Washington.

“Over the course of this debate, Fannie and Freddie will have generated at least $250 billion to $300 billion in earnings, far in excess of the $187 billion that Treasury invested in them,” LaVier said. “Are you going to tell me you can’t redeem the $33 billion of junior preferred, repay Treasury in full plus a significant profit, and fix the system?”

Perry faces a “big hurdle” in court because the law governing the government’s conservatorships bar most types of lawsuits, said Patrick J. Smith, a partner at Ivins, Phillips & Barker in Washington. Nader said in an interview he thought Perry’s case was the strongest. The government changed the rules “midstream” after the bailout, Nader said.