Fannie And Freddie Revisited

Friday, December 11, 2020

The United States Supreme Court heard the oral argument this month in Collins v. Mnuchin, a high-stakes case worth roughly $29 billion. The case was argued on terms that ordinary people would rightfully find utterly unintelligible. At stake was the legitimacy of the key features of the federal bailout of Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that dominate the residential home mortgage market.

The bailout began in the frenzied days after the 2008 banking crisis. Initially, the federal government agreed to contribute more than $188 billion to the two companies in exchange for senior preferred stock that carried with it a 10 percent dividend, or $18.8 billion per year. That deal was not negotiated by the trustees of Fannie and Freddie, as they had been ousted from their positions by a conservator, Edward DeMarco, the acting director of the Federal Housing Finance Agency (FHFA), which was given power to oversee the residential mortgage market. DeMarco had an obvious conflict of interest in making this deal because he was negotiating against the Department of Treasury, where he had been a senior official between 1993 and 2003.

The 2008 deal remained stable until August 2012, when DeMarco and Treasury renegotiated the transaction, such that the 10 percent dividend was eliminated in favor of a Net Worth Sweep (NWS) in the Third Amendment to the original deal. That NWS took all the dividends in perpetuity from both Fannie and Freddie and paid them into the federal treasury, leaving the companies with no cash, no liquidation preferences, and no voting rights, so that their only asset was a lawsuit against both FHFA and Treasury Secretary Steven Mnuchin as a stand-in for the United States government.

To an ordinary person, this particular transaction might look like a government looting of the companies. Thus, in oral argument, Justice Breyer asked why a takings claim had not been brought in response to the de facto “nationalization” of the two GSEs. Sadly, several claims of that sort had been brought early on but were beaten back by a dubious array of arguments both before the District Court in Perry Capital v. Lew (2014) and the United States Court of Appeals for the District of Columbia in Perry Capital v. Mnuchin (2017).

Thus, one common government refrain, repeated in oral argument, was that the NWS was strictly necessary to break an endless cycle whereby Treasury would constantly have to lend money to the GSEs in order for them to make their annual dividend payments. But there were two decisive responses to this government claim: first, that insolvency was no longer an issue as of August 2012; and second, that the original agreement dealt with the matter of delayed payment by allowing the GSEs to defer payment so long as they were prepared to pay 12 percent interest on the deferred balances, an option that Judge Lamberth in Perry Capital v. Lew improperly disregarded as a penalty.

Moreover, citing Section 4617(b) of the 2008 Housing and Economic Recovery Act (HERA), the government claimed in the Supreme Court that the expropriation of all assets was consistent with the role of the FHFA as a conservator, whose job was to “put the regulated entity in a sound and solvent condition,” which the NWS made possible. To top it all off, the government claimed that the individual shareholders had only a “derivative” interest such that they had no standing to sue at all under that provision, as the FHFA “shall, as conservator . . . and by operation of law, immediately succeed to—(i) all rights, titles, powers, and privileges of the regulated entity. . . .”

Both of these provisions, which were each before the court, were designed to ensure that the FHFA had the power to bring and settle all claims against third parties in order to enhance the estate that it was conserving. The conservator may succeed to various rights, but remains subject to the standard obligations of the regulated entity. Yet in the initial round of court cases, Section 4617(b) was read bizarrely to hold that the FHFA could never be held legally accountable to the shareholders for transferring all the GSE assets to the Treasury, as if HERA authorized mass confiscation through FHFA and Treasury collusion against the GSE private shareholder.

The shenanigans in the early cases were neatly exposed by Judge Don R. Willett in his Fifth Circuit en banc opinion below. But when the Supreme Court agreed to hear Collins, it pushed aside any claim for the expropriation of intangible assets. Instead, the focus turned to the question of whether the constitutional doctrine of separation of powers allowed Congress to vest all the powers of FHFA in a single head who was not subject to removal from office at the behest of the president. Ever since the watershed case of Humphrey’s Executor v. United States (1935), the Supreme Court accepted independent agencies—that is, those of which the president did not have a removal power—as part of our structural Constitution. Its rationale—that the activities of the Federal Trade Commission “are neither political nor executive, but predominantly quasi-judicial and quasi-legislative”—has raised more than one eyebrow, even though it is today settled law.

The question before the court in Collins was whether it was permissible to vest the powers of an independent agency in the hands of a single entrenched executive. That issue was recently addressed by the Supreme Court in Seila Law v. Consumer Financial Protection Bureau (2020), which held that independent administrative agencies (whose status has always been dubious under the original constitutional design) were constitutional only if they met one of two conditions. Either the agency had to have a multimember board, or its single director had to be removable at will by the president. The CFPB had a single director, who was removable only for “inefficiency, neglect of duty, or malfeasance in office,” which is tantamount to total insulation for a five-year term that necessarily exceeds the term of the appointing president. The separation of powers issue came to a head when Seila Law refused to supply documents and records subpoenaed by the CFPB.

In that context, the separation of powers inquiry made sense. The Supreme Court refused to confer additional powers on the CFPB, as “the Constitution—with the sole exception of the presidency—scrupulously avoids concentrating power in the hands of any single individual.” But when it came to the question of remedy, another question remained: could the cause for removal provisions be severed from the rest of the CFPB? To this question, the Supreme Court gave the right affirmative answer: The “duties remain fully operative without the offending tenure restriction.” Therefore, on remand, the current director can reissue the same subpoena within the revised statutory scheme.

The landscape under the FHFA is different. The cry for judicial relief arises some eight years after the NWS order, so it is no longer possible simply to restart the proceedings now that the head of the FHFA serves at the pleasure of the president. Instead, the question becomes what to do about the multiple government actions ordered by a single  agency head, whose appointment violated constitutional norms, that drained Fannie and Freddie of all their assets. It would be simple to calculate what the current capitalization of Fannie and Freddie would be if the NWS had never been implemented, and those funds could be restored to Fannie and Freddie.

But what about countless other FHFA decisions that have introduced general regulatory policies and resolved specific disputes with outside parties? Severability of the “for cause” provision would keep those decisions intact, only requiring that the FHFA head serves at the pleasure of the president going forward. But all interim acts between 2008 and the present would remain, as there is no reason to suppose that the president would have exercised his removal power in the interim, or that, if he did, the next director would have undone the NWS, which still enjoys broad bipartisan support.

Thus, the two stark alternatives mentioned in oral argument by Justice Neil Gorsuch were these. First, void all decisions that were made under the under earlier regime, at which point the government owes $29 billion back to the GSEs. Or treat the mistake as harmless error, given that nothing would have changed if the FHFA had been originally drafted in its correct form. Justice Gorsuch was inclined to the first alternative, and he cited Lucia v. Securities and Exchange Commission (2018) in support of that conclusion. There, the court vacated a judgment rendered by an administrative judge who had not been properly appointed, which set the stage for a second trial when a new administrative law judge was appointed to hear the case.

But does the analogy really work here? Seila and Lucia were individual suits that could be retried, while the NWS sweep was a comprehensive deal that could not be reimposed eight years after it was created, given the prospect of a new round of substantive challenges. In Collins, the justices collectively spent virtually no time addressing the merits of the underlying deal, which is troublesome. Moreover, as a doctrinal matter, the question remains of whether the fatally flawed NWS should tilt the balance in Collins in favor of restoring the funds to the two GSEs. Reading the back-and-forth arguments in Collins makes it look as if the court will follow Seila by striking down the statutory provision that vests exclusive power in a single official. But that structural remedy would not transfer a single dollar back to the individual plaintiffs.

So the key issue turns on the choice of remedy. In my view, administrative law is the wrong vehicle to evaluate the legality of the NWS. But at this point, the court faces the hard choice of whether to ignore the underlying nationalization by severing the removal provision and upholding the sweep, or by using the separation of powers argument to void the underlying nationalization. There is no need to undo all the actions of FHFA, most of which raise no serious constitutional issues. But the claims of substantive justice should be accorded real weight, such that a remedy that goes too far as an administrative law matter should be selected over one that forces the plaintiffs to go home empty-handed.