Last week’s headline financial story was full of good news for the body politic. The United States Treasury reported a handsome second-quarter profit of $118 billion, which could cut down the deficit and postpone any politically charged negotiations over raising the debt ceiling. Half of that surplus comes from a combination of revenue increases from a slowly improving economy and expenditure cuts introduced in early 2013. The second half consists of a $59 billion “dividend” from Treasury’s “investment” to bail out The Federal National Mortgage Association (Fannie Mae) and The Federal Home Loan Mortgage Corporation (Freddie Mac).
To call that money a “dividend” relies on a profound public misunderstanding of the complex transactions that generated this ill-begotten Treasury bonanza. These transactions are being challenged in four separate lawsuits, which were recently filed, that attack the propriety of virtually every government action during the turbulent past five years. (Full Disclosure: within the past several months, I been hired by several hedge funds to advise them privately on the legal issues surrounding these events.)
The oft-neglected back-story of the “Fannie and Freddie Dividend” casts these transactions in a much darker light. Quite simply, the behavior of the U.S. government over the past five years has been marred by grave legal violations of bedrock principles underlying corporate, administrative, and constitutional law. The Back-Story
Act One: Organizing the Bailout
Prior to August 2008, both Fannie Mae and Freddie Mac were privately owned, publicly traded, and consistently profitable corporations that had issued large amounts of common stock and multiple classes of preferred stock. But both Fannie and Freddie were in obvious distress during the run-up to the September 2008 financial market meltdown, which prompted Congress to pass the Housing and Economic Recovery Act of 2008 (HERA) in July of that year. That behemoth law authorized the Federal Housing Finance Administration (FHFA) to place the corporations into a temporary conservatorship to preserve and to manage their assets in ways that would help stabilize the housing market.
Pursuant to that authority, the FHFA became conservator of both companies in September 2008. It promptly made a deal with the Department of Treasury under which Treasury would advance $100 billion (extended in May 2009 to $200 billion) in exchange for $1 billion in shares of senior preferred stock, which had an original face value of $1 billion dollars. That preferred stock would be increased dollar-for-dollar by any sums that the Treasury invested into either corporation and it carried a 10 percent dividend. At the same time, the Treasury received warrants to purchase 79.9 percent of the common stock of each entity for a nominal price measured in tiny fractions of a penny.
Section 1117 of HERA gave Treasury broad discretion on the terms and conditions that attached to its preferred stock, but it also required Treasury to take into account a number of conditions that related to the soundness of the government’s security for its advances and to the “orderly resumption or private market funding or capital market access,” which would allow Fannie and Freddie to each maintain their status “as a private shareholder-owned company.” Shortly after the 2008 deal went into effect, the value of the common and preferred shares both plummeted.
Act Two: The Third Amended Agreement
I will pass by the many complications that occurred between September 2008 and August 2012 to focus on The Third Amendment to the original stock purchase agreement of August 17, 2012, signed by both Edward Demarco, Acting Director of FHFA, and then Treasury Secretary Timothy Geithner.
Its key provision simply ordered what the Treasury trumpeted, in bold type, would be (as of January 1, 2013) “a full income sweep of All Future Fannie Mae and Freddie Mac Earnings to Benefit Taxpayers for Their Investment.” Treasury announced the sweep only after it became clear that both Fannie and Freddie were returning to profitability. The stock prices of both sets of shares plummeted. By the terms of the deal, nothing was left for either’s set of shareholders in the absence of political relief or a successful lawsuit.
The Flaws of the Government Position
The Conservator’s Conflict of Interest
The shareholders’ grievance is quite simple: the disappearance of their wealth. The purpose of a conservatorship is to preserve the assets for the benefit of the individuals whom it represents, which in this instance covers both classes of shareholders. Accordingly, the conservator represents the shareholders in their relationship with the government. Under standard corporate law principles, that conservator is bound, as his name suggests, by a strong fiduciary duty to protect its assets for the benefit of both its common and preferred shareholders.
In this case, however, the designation of the FHFA as the conservator created an impossible conflict of interest. The Boards of Directors of Fannie and Freddie were shut out of the deliberations that took place exclusively between branches of the federal government.
Given that exclusion, the terms of the financial deal between the corporations and Treasury must be examined to see that in discharging their mandate “to protect the taxpayers,” the two government parties did not run roughshod over the issues of the preferred and common shareholders. Yet, as the plaintiffs allege in Washington Mutual v. United States, there was ample evidence that Treasury exaggerated the financial dangers to Fannie and Freddie in 2008, and thus imposed financial terms that were far too favorable to its own interests, since both Fannie and Freddie had substantial amounts of liquid assets to meet any claims. No wonder share prices plummeted in response to both the 2008 and 2012 deals.
By the standards of corporate governance, these transactions are not protected by the ”business judgment” rule, which is intended to give protection to the good faith judgment of corporate fiduciaries when they are acting in the best of interests of the shareholders with outsiders. That rule is needed to protect officers and directors, for no one will take those jobs if he knows that he gets nothing special when he works well, but suffers huge liabilities if an uncertain deal turns sour.
In this case, however, we have a manifest case of self-dealing between branches of the United States government, at which point the law protects the shareholders by insisting that the parties to the transaction show that it supplied full value to the shareholders. At the time of the 2008 deal, the Office of the Inspector General inside FHFA concluded that the deal had rendered the common and preferred shares “almost worthless.”
It takes no special acumen to realize that the 2012 transaction was completely one-sided; FHFA and Treasury used a fancy set of legal maneuvers to strip both corporations of their assets for the sole benefit of the government. Generally, senior preferred shareholders are entitled to recover their principal and interest in full, after which their shares are cancelled. In this case, the government did precisely the opposite. It treated Fannie and Freddie as gifts that keep on giving, wiping out all shareholder profits.
This breach of duty is so blatant that the only serious question is how best to unscramble the omelet. To make a long story short, there are two ways forward. First, and easiest, is simply to annul the August 2012 Amendment so that the government uses its recent receipts to write down the principal and interest owed prior to that date. Second, and trickier, is to reevaluate the terms of the 2008 transaction and write down the size of the government’s senior preferred shares to fairly reflect the financial condition of the company at the same time.
The Administrative Procedure Act
The August 2012 actions are also in flat violation of the basic duties of government actors under the Administrative Procedure Act (APA), which is addressed in one claim filed in Fairholme Funds v. FHFA and a second filed in Perry Capital v. Lew. The gist of these two actions is that Treasury and FHFA are not at liberty to ignore all of the procedural safeguards that were explicitly built into HERA. Any decision of this magnitude must be set aside when no government official has addressed the explicit statutory “considerations” that are supposed to guide their behavior.
There is no way that a statutory scheme that was intended to nurse Fannie and Freddie back to health as private corporations can be used unilaterally by the government to devour the interests of the very private shareholders that they were intended to protect. Government actions that don’t comply with the minimum standards of the APA should have no force and effect. Thus, even if the 2008 transaction stands, the 2012 transaction should be nullified, and the private and common shares restored.
The Takings Issue
The third approach to this problem, taken both in Washington Mutual and Cacciapelle v. United States, hones in on the de facto confiscation of the common and preferred stock of these companies by the unilateral government action. On this view, the government can keep the shares so long as it buys out the shareholders at fair market value. The law of takings, with its just compensation requirement, is intended to make sure that the government does not, in the famous words of the 1960 case of Armstrong v. United States, force “some people alone to bear public burdens which, in all fairness and justice, should be borne by the public as a whole.”
Regrettably, that is exactly what is being done here. The government could never announce that it had decided to seize the shares of Fannie and Freddie, without compensating their owners. Nor can it circumvent that fundamental principle by “amending” a supervisory agreement so that it sucks all the wealth out of those shares. The government’s position is yet more precarious when one considers that the crisis in the housing market was due to the reckless policies that the United States forced on Fannie and Freddie prior to 2008. If Congress makes the mess, it can hardly expect the shareholders whom it targeted to bear the brunt of its misdeeds.
Some Ominous Social Implications
All three routes therefore lead to the same conclusion. The whole sorry episode represents a form of serious government coercion, with public officials attempting to run roughshod over bedrock principles of corporate, administrative, and property law. It is therefore a sad commentary on the current situation that Republican Senator Bob Corker of Tennessee has introduced the high sounding Housing Finance Reform and Taxpayer Protection Act that is intended to wind down the operations of Fannie and Freddie, which does nothing whatsoever to undo the massive property grab undertaken over the past five years.
There is no doubt that this legislation will attract popular support because it demonizes hedge funds and profits taxpayers in the short run. But it is vital to remember the long run. This dispute involves lots more than a simple battle over the proceeds of profitable ventures. All capital markets depend on the strong protection of the rule of law so that firms that invest their capital today can be confident that the government will not steal it away by stealth and artifice tomorrow, which is just what is happening now on a multibillion dollar level.
In 2009, I wrote at some length about the dangers of “political bankruptcies” in relation to the General Motors and Chrysler bailouts, which also ran roughshod over the rule of law. At the time, people said it was a one-off situation. After Fannie and Freddie, those words ring hollow. The only way to raise capital at the front end is to stick to the rules of the game throughout the transaction. We now seem to have some bipartisan support for the opposite position, which is one more sober reminder of how far the nation has drifted from the sound and enduring principles of strong property rights and limited government.
Richard A. Epstein, Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, Laurence A. Tisch Professor of Law at New York University, and senior lecturer at the University of Chicago, researches and writes on a broad range of constitutional, economic, historical, and philosophical subjects. He has taught administrative law, antitrust law, communications law, constitutional law, corporate law, criminal law, employment discrimination law, environmental law, food and drug law, health law, labor law, Roman law, real estate development and finance, and individual and corporate taxation. His publications cover an equally broad range of topics. His most recent book, published in 2013, is The Classical Liberal Constitution: The Uncertain Quest for Limited Government (2013). He is a past editor of the Journal of Legal Studies (1981–91) and the Journal of Law and Economics (1991–2001).