Last week, the government announced that it will receive another multi-billion dollar “dividend” from Fannie Mae and Freddie Mac. That payment will return to the United States Treasury (with interest) all of the $187 billion in bailout money lent to the two mortgage giants after September 2008, pursuant to the Housing and Recovery Act (HERA) passed in July 2008. HERA authorized the newly minted Federal Housing Finance Agency (FHFA) to throw both Fannie and Freddie into a statutory conservatorship, and required FHFA to manage the assets of both corporations to facilitate their orderly return into private hands upon repayment of the government advances.
Illustration by Barbara Kelley
The initial bailout terms were contained in a Senior Preferred Stock Purchase Agreement (SPSPA). Under its terms, each corporation had to issue a new class of senior preferred stock to the United States, which bore interest at 10 percent per annum. That sum increased to 12 percent if Fannie and Freddie chose to conserve cash instead of paying dividends. For the next two or so years, as conditions in the housing market improved, the arrangement proceeded more or less as planned. The entire legal landscape, however, was radically changed in August 2012, when the Third Amendment to the 2008 SPSPA was passed. It called for a “net worth sweep” under which FHFA and Treasury entered into a deal that magically converted all the net receipts of Fannie and Freddie as “dividends” to be paid to the government.
This audacious deal ensured that the two corporations would never pay off their debts to the United States, no matter how much money they earned. The Third Amendment has been subject to withering criticism, most recently by David Skeel who, writing in the Wall Street Journal, rightly charged the federal government with “astonishingly duplicitous behavior.”
By way of full disclosure, I consult with several hedge funds with positions in Fannie and Freddie. From that perspective, as I have already ready written in previous Defining Ideas columns, the government shenanigans fairly leap out of the text of the Third Amendment. But Gretchen Morgenson’s New York Times piece, “The Untouchable Profits of Fannie Mae and Freddie Mac,” contains two new revelations that only add fuel to the fire.
The first concerns the release of a key internal Treasury memo dated December 20, 2010 from Jeffrey Goldstein, then undersecretary of domestic finance, to then-Secretary of the Treasury Timothy Geithner, which referred unequivocally to “the administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future.” The Treasury has tried to backtrack from that position by insisting that the memo was “only about the importance of repaying the taxpayers for the enormous investment that they made in the G.S.E.’s if the G.S.E.’s ever generated positive returns, which at the time was uncertain to return.”
Not so fast. As Ralph Nader rightly observed in his February 1, 2014 letter to Secretary of the Treasury Jacob J. Lew, no one disputes the government’s claim of first priority to Fannie and Freddie assets. Yet the belated government explanation ignores its intended wipeout, and thus further covers up the simple point that the scheme behind the Third Amendment was hatched some 18 months before that Amendment was put into effect.
This one-sentence revelation casts in new light the decision of the Federal Deposit Insurance Company on three occasions to sell large blocks of Fannie and Freddie shares, without first disclosing Treasury’s intention to drive the value of these shares to zero. At the very least, the actions of these two closely-intertwined government agencies raise the specter of securities fraud—the kind of conduct that invites criminal investigation of any private parties who behave in similar fashion.
These recent events strongly suggest a continuous pattern of bad-faith government conduct. What they do not do, however, is create a case for money damages against the government that will help the long-term private shareholders of Fannie and Freddie who did not trade during this period. But the real game is the entire dividend stream that has been diverted from all Fannie and Freddie shareholders under the Third Amendment. The key inquiry is therefore into the government defenses against the three charges in the underlying law suits: wealth confiscation, the abuse of administrative authority under FHFA, and the breach of its fiduciary duty to Fannie and Freddie’s private shareholders.
The government’s task is not an enviable one, because the cozy deal between FHFA and Treasury looks like the worst form of self-dealing. Recall that both Edward DeMarco, then acting director of FHFA, and his key aid Mario Ugoletti both came to FHFA from Treasury. To remove any taint from the deal, the government has to show first that it exercised due diligence to see that the deal was fair to all parties, and, second, that, more critically, the deal viewed as a whole was in fact fair the private shareholders. The government has done nothing to satisfy either obligation.
Faced with these serious obstacles, the first line of the government’s defense is to argue that none of the private shareholders has standing to challenge this collusive deal because HERA provides that the FHFA as conservator shall “immediately succeed” to all shareholder rights in the GSE. That transfer of power is fine insofar as it lets FHFA pursue GSE claims against third persons. The benefit of the rule is that it prevents any third party from wiggling out of its obligations to Fannie and Freddie by arguing that the suit was brought by the wrong party.
It defies common sense, however, to let this language insulate FHFA and Treasury from all lawsuits that the private shareholders bring against them for abuse of power. Now the government faces an unpleasant dilemma. Either it can admit that the “all rights” provision cannot be used to throw the plaintiffs out of Court, or it has to recognize that the statute, by shutting the courtroom door to shareholders, amounts to a per se violation of the standard procedural norms of due process, which require the government to guarantee to any interested party a judicial hearing to protect its property.
Nor does the government position become defensible once the door is forced open. Most strikingly, at no point in its legal papers does the government even acknowledge that its advances had been largely repaid. Instead its dubious defense rests on two points: first, that “the value of Treasury’s commitment to the GSEs was ‘incalculably large”; and second, that in light of the dangerous situation in 2008, “equity holders in the GSEs had no expectation that they would have access to any positive returns that the GSEs might experience in the future.”
Wrong on both counts. First, the level of the Treasury commitment was not “incalculably large”: it was $188 billion, all of which will shortly be repaid. Second, the government indulges in skillful wordplay on the term “expectation.” I may expect—i.e. predict—that my shares of stock may never be in the money. But in so thinking I have not renounced my right to cash in those shares when they have positive value. No negative prediction of future consequences can wipe out an entitlement when and if the future unfolds beneficially.
Next the government offers its own twisted account of the Third Amendment. Its major ploy is to insist that given the size of the advances “it was unlikely that the GSEs would earn enough net income—even in years when they were otherwise profitable—to pay Treasury its dividends without the need to take further draws from Treasury.” The Third Amendment was supposed to end this “vicious circle” and lead to “improved market confidence” in Fannie and Freddie.
Really? Note that the 2008 agreement contains a standard provision that would avoid the senseless cycle of repaying dividends with fresh advances from Treasury. FHFA could unilaterally decide to hold back needed cash by paying 12 percent interest on late payments. It was hardly necessary to bankrupt Fannie and Freddie to avoid further advances.
Worse still, the government committed a serious tactical error in filing its motion to dismiss the entire case before trial. A well-argued MTD takes as true all the allegations in the complaint. But the government’s papers denied that Fannie and Freddie had sufficient funds to pay off these claims when the Third Amendment went into effect. Factually, the claim seems absurd in light of the robust financial performance of Fannie and Freddie after August 2012. But once that assertion was made, the plaintiffs in Fairholme Capital demanded, through their attorney Charles Cooper, extensive discovery in order to examine the government’s aggressive claim.
This past week Judge Margaret Sweeney granted Cooper’s motion, sweeping aside the government’s objections that the claims were not “ripe” for review on the ground that “1) future profitability is unknown, and 2) both Fannie and Freddie are still in conservatorship.” Those claims border on the frivolous, given that the government had to know something about its profitability before implementing the Third Amendment. Nor is it credible to assume that the conservatorship should go on forever after the advances have been repaid.
As Judge Sweeney noted, since this evidence “is solely in possession” of the government, discovery is required to equalize the balance, at which point all documents and discussions relating to Treasury’s key decisions should become public record. No wonder the shares of Fannie and Freddie rose substantially on this late-breaking news.
What Is To Be Done?
Going forward, it is hard to disagree with David Skeel that “ideally the government should undo the 2012 sweep,” which would end litigation in which the government’s position seems ever more precarious. But if the government continues to fight, it gains nothing from delay. Recall that the plaintiffs demand is solely to receive proper credit for the repayment of the government’s advances. The offset for that delay comes in the form of interest that the government has to pay on its late obligations.
It seems, however, that the government has decided to circle the wagons. Republican Ed Royce’s H.R. 3901 is a bill that carries the jingoist title “Pay Back the Taxpayers Act of 2014,” which provides explicitly that the payments to Treasury under the Third Amendment shall go “into the General Fund of the Treasury and shall be used only for reducing the budget deficit of the Federal Government.”
This audacious legislative maneuver attempts to deflect the constitutional and administrative challenges to the Third Amendment by announcing that Congress thinks that the government should keep the Fannie and Freddie dollars. How ironic. Right now the Congress is desperately working to find ways in which to increase the private capital invested in mortgage markets. But who will play along when the legislative and executive branches rig the rules after the game is underway? First there was Chrysler and GM, now this.
A government victory against the Fannie and Freddie shareholders may well make the private mortgage lending market a distant memory. Indeed, anyone listening to Janet Yellen bob and weave in response to Representative Michael Capuano’s pointed questions about Fannie and Freddie should realize that there is no concerted political will in Washington to get real on the ominous implications of the government’s unconstitutional money grab.