Author Archives: David Reiss

Reiss on Fannie/Freddie Suits

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Bloomberg BNA quoted me in No Basis for Discovery by GSE Investors, Treasury Department, FHFA Memos Say. It reads

[Reproduced with permission from BNA’s Banking Report, 102 BBR 417, 3/11/14. Copyright  2014 by The Bureau
of National Affairs, Inc. (800-372-1033) https://www.bna.com]

The Treasury Department and the Federal Housing Finance Agency March 4 said a federal judge should deny a motion for discovery in lawsuits by Fannie Mae and Freddie Mac investors, citing an agreed-upon schedule and saying the motion would do nothing to address legal questions at the core of the case (Fairholme Funds v. Federal Housing Finance Agency, D.D.C., No. 13-cv-01053, 3/4/14).

In its memo filed in the U.S. District Court for the District of Columbia, Treasury said Fairholme’s Feb. 12 motion for discovery (31 DER EE-6, 2/14/14) would be “improper” under a November scheduling order, and urged the court to dismiss the Fairholme suit and related cases.

“These cases should proceed on the agreed briefing schedule, which already provided ample time to the plaintiffs to file their substantive briefs, and the Court, upon review of a completed set of briefing with respect to the defendants’ dispositive motions, should dismiss these cases,” Treasury said March 4.

In its March 4 filing, the FHFA memo said “no discovery is necessary to assess the purely legal arguments” before the court, adding the Housing and Economic Recovery Act of 2008 (HERA) bars second-guessing of the FHFA’s actions as conservator of Fannie Mae and Freddie Mac.

Litigation Ongoing

The suit is one of several in at least two district courts and the U.S. Court of Federal Claims that challenge Treasury and FHFA action in August 2012 that restructured contracts governing preferred stock issued by the two government-sponsored enterprises.

Fairholme and other investors say the August 2012 amendment amounted to an expropriation of their assets and have variously sought damages and compensation in response.

The government has sought to dismiss the Fairholme case and others, but in its Feb. 12 motion, Fairholme said the government’s motion to dismiss was too expansive and raised questions that require access to government documents, e-mails and other materials.

Arrowood Indemnity Co., the plaintiff in a related case in the district court and a separate case in the Claims Court, Feb. 20 sought to link its own bid for discovery to Fairholme’s (36 DER EE-8, 2/24/14).

Fairholme has already prevailed on its discovery motion in the Claims Court. In a Feb. 26 order, Judge Margaret M. Sweeney granted Fairholme’s motion for a continuance to pursue discovery in that case.

March Reply Scheduled

In the district court, Fairholme is scheduled to respond to the government’s March 4 memos by mid-March.

“We are reviewing the opposition briefs filed by the defendants just yesterday, and we will respond to them in our reply brief, due on March 14,” a spokesman for Fairholme told Bloomberg BNA March 5.

High Stakes Seen

Professor David Reiss of Brooklyn Law School in New York March 5 said discovery usually occurs after motions to dismiss have been decided.

In this case, he said, “the stakes are so high and the quality of lawyering so high that there is litigation over the scheduling order itself.”

“This is a hard-fought battle and the issues are incredibly complex,” Reiss told Bloomberg BNA. “Each side characterizes their arguments as relatively straightforward, but I think the judge will have a hard time parsing out the issues, because there are different statutory regimes, policy issues and the like that must be rationalized with each other. I think this is just the beginning of a long slog,” he said.

What $4 Billion Does for Homeowners

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Enterprise released a Policy Focus on What the JPMorgan Chase Settlement Means for Consumers: An Analysis of the $4 Billion in Consumer Relief Obligations. It opens,

On November 19, 2013, JPMorgan Chase reached a record-setting settlement deal with the federal government’s Residential Mortgage-Backed Securities (RMBS) Working Group for $13 billion, which included $4 billion in consumer relief for struggling homeowners and hard-hit communities.

This brief examines how the $4 billion obligation will likely flow to consumers over the next four years. According to the settlement terms, eligible activities for which JPMorgan Chase will receive credit broadly include: loan modifications; rate reduction and refinancing; low- to moderate-income/disaster area lending; and anti-blight work. (1)

Enterprise projects that JPMorgan’s $4 Billion obligation will

translate into $4.65 billion in relief for existing homeowners, with an additional $15 million going to homebuyers, and as much as $380 million in cash and REO properties allocated to reducing foreclosure-related blight. Our analysis projects that over 26,500 borrowers will receive a total of $2.6 billion in principal forgiveness, which translates into $1.5 billion in credit toward the bank’s obligation. Forbearance will be extended on 17,000 loans, and slightly more than 7,000 second liens will be fully or partially forgiven. In addition to forgiveness or forbearance, we anticipate the interest rates on approximately 26,500 loans will be reduced, resulting in a real borrower savings of $1.4 billion. (1)

We’re talking about some pretty big numbers here, so it might be useful to break them down on a per borrower basis.

  • 26,500 loans will receive interest rate reductions resulting in $1.4 billion in consumer benefit, or $52,830 per loan.
  • 26,500 borrowers will receive $2.6 billion in principal forgiveness, or $98,113 per homeowner.

The report, unfortunately, does not parse these big numbers out so well. For instance, do they reflect savings over the expected life of the loans or over the remaining term? We also do not know whether these changes, large as they are, will leave sustainable loans in their place. So, this is a report provides a useful starting point, but some very big questions about the settlement still remain to be answered.

Housing Affordability Challenges

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The Center for Housing Policy has issued a report, The Housing Affordability Challenges of America’s Working Households. It finds that

Overall, 15.6 percent of all U.S. households (18.1 million households) were severely housing cost burdened in 2012. Severely cost burdened households are those that spend more than half of their income on housing costs. Renter households are more than twice as likely to be housing cost burdened than owner households. In 2012, 24.7 percent of all renter households were severely burdened compared to 10.5 percent of all owner households. (1)

Unsurprisingly, “the nation’s lowest income households face the most severe challenges” as nearly “eight in ten extremely low-income working households, and over a third of very low-income working households, are severely housing cost burdened.” (3) The paper concludes that “unless housing production increases substantially — particularly in the highest cost markets — rents are going to continue to rise . . ..” (4)

This simple point — that there is not enough supply to meet demand is made time and again by scholars and policy analysts. But that simple truth bangs up against the arguments of those who oppose development for a variety of reasons:  because it can be an agent of localized gentrification, because it changes the fabric of communities, because it can benefit business interests.

There is some truth to all of these arguments and many people can make them in good faith. But one cannot be a proponent of affordable housing without supporting a meaningful increase in housing production. Here in NYC, the de Blasio Administration has appeared to embrace this fundamental truth. In many parts of the country, however, people claim to support affordable housing and strict limits on housing construction. Affordable housing advocates have to call them out on that contradiction as the two policies are in direct conflict with each other.

All the demand side subsidies in the world (like Section 8 vouchers) won’t get people into housing if the supply isn’t there in the first place.  Build it and working households will be sustainably housed. Don’t build it and they won’t be.

Fannie and Freddie Boards: Caveat Fairholme

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Fairholme Capital Management has sent stern letters to the the boards of Fannie Mae and Freddie Mac (the letters are essentially the same). Fairholme’s funds have millions of common and preferred shares in the two companies and Fairholme has taken a multi-pronged to trying to wring some value out of those shares. It has sued the federal government. It has offered to buy the two companies’ mortgage guaranty operations. Now, it is threatening the board of the two enterprises with personal liability for their actions and inaction.

In regard to the cash dividends that the two companies have paid to the Treasury as a result of their Preferred Stock Purchase Agreements (as amended), Fairholme writes,

It is common sense that no Board should approve cash distributions without independent financial advice as to the effect of such payments on the Company’s safety, soundness, and  liquidity. Moreover, corporate laws generally prohibit the payment of dividends in many circumstances, imposing personal liability on Directors for illegal dividends – a liability that, pursuant to the Housing and Economic Recovery Act of 2008, is not assumed by the Conservator. (Fannie Letter, 3) (emphasis added)

This is a straightforward threat that will likely get the attention of the directors of the two companies and get them to check in with their D&O insurer before taking any further actions. But it is genuinely unclear what they should be doing at this point.

As I note in a forthcoming article, An Overview of the Fannie and Freddie Conservatorship Litigation (NYU J. Law & Bus.), the Fannie/Freddie shareholder litigation raises all sorts of complex and novel legal issues, and I am not willing to predict their outcomes. But I will go as far to say that Fairholme presents the way out of this mess as far clearer than it is — “Various solutions are simple, equitable, and need not be contentious.” (5) The ones that Fairholme has in mind likely involve large payouts for shareholders, one way or the other.

At the same time that Fairholme presents the solution as simple, it does acknowledge (as it really must) that the problem itself is not:  “we are aware of no circumstance in which the controlling shareholder and its affiliates simultaneously act as director, regulator, conservator, supervisor, contingent capital provider, and preferred stock investor.” (3-4) Yup, this is one big mess with no real precedent. I am confident, however, that the federal government has no interest in reaching a settlement with shareholders that shareholders would find acceptable. So, no end in sight to this aspect of the Fannie/Freddie situation, a far as I can tell.

Appraisals in the Coal Mine

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The Federal Housing Finance Agency Office of Inspector General released an Audit Report, FHFA’s Oversight of the Enterprises’ Use of Appraisal Data Before They Buy Single-Family Mortgages. As the IG notes,

Assessing the value of collateral securing mortgage loans is one of the pillars in making sound underwriting decisions. Since September 2008, the Federal Housing Finance Agency (FHFA) has operated Freddie Mac and Fannie Mae (the Enterprises) in conservatorship, due to poor business decisions and risk management that led to enormous losses. While in conservatorship, the Enterprises have relied on Treasury’s financial support to operate in the secondary mortgage market, buying loans in order to provide needed liquidity to lenders. In 2010, FHFA directed the Enterprises to improve single-family residential loan quality and risk management through, among other things, developing a uniform collateral data portal (portal).

Unfortunately, the IG found that

  • from January 2013 through June 2013, Fannie Mae spent $13 billion buying over 56,000 loans even though the portal’s analysis of the associated appraisals warned the Enterprise that the appraisals were potentially in violation of its underwriting requirements.
  • from June 2013 through September 2013, Freddie Mac spent $6.7 billion buying over 29,000 loans despite the portal warning the Enterprise that either no property value could be provided or the value of the property was in question.

  • the Enterprises bought nearly $88 billion in loans when system logic errors in the portal did not allow them to determine if the appraiser was properly licensed to assess the value of the properties, which served as collateral for the loans.

The IG did not characterize these problems as particularly worrisome, but I wonder if they are somewhat symbolic of the limbo state that the Enterprises find themselves in. Like canaries in a coal mine, they alert us to a serious problem.

Neither private companies nor government instrumentalities, the Enterprises must stagger on until the federal government decides what to do with them. Let’s hope that the Enterprises are not silently building up to another crisis, one not driven by the profit-motive as the last one was, but driven by bureaucratic incompetence. “Bureaucratic” in the sense of the “rule of no one,” as Mary McCarthy defined it.

Fannie and Freddie’s current profitability should not be used as an excuse to delay reform further. They are too important to have been left in limbo for so long.

 

Reiss on Marketplace: Cash Cows to Slaughter

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I was interviewed on Marketplace for its story, Fannie and Freddie: Cash Cows Avoid The Slaughter? (sound file) The text of the story reads

We are making money – the tax payer, that is – on Fannie and Freddie Mac.

When Freddie Mac hands the treasury a $10.4 billion dividend next month, tax payers will have received more money in interest than was put in. (Technically the two institutions still owe the principal on the loan that bailed them out, but the interest they’re paying will shortly exceed that amount).

But.

There always is a but with these things.

Making money for the tax payer isn’t good if you ask those who want reform.

Back during the financial crisis, conservatives and liberals disagreed over whether Freddie and Fannie were a victim of or a cause of the housing collapse, but they agreed that the institutions needed reform. The profits are throwing a wrinkle into this debate.

“As long as Fannie and Freddie continue to pay substantial amounts of money to the government, they are looked at by some people in Congress as a great source of revenue that reduces the deficit,” explains Peter Wallison with the American Enterprise Institute. His concern – shared by reformers on both sides of the political spectrum – is that if Fannie and Freddie become cash cows, congress won’t want to touch them.

David Reiss, professor of law at the Brooklyn Law School, agrees. He says the financial crisis wasn’t a one time problem.

“We should think of it as that we dodged a bullet. There’s fundamental problems with the Fannie and Freddie business model which rests on this notion of privatizing profits and socializing losses.”

Freddie and Fannie buy mortgages from lenders, and then bundle them into “mortgage backed securities” that can be sold to investors. It’s useful because it converted illiquid mortgage loans into liquid securities. In plain English, it means a bank or investor who made a mortgage loan to someone didn’t have to wait around for 30 years to be paid back. They could sell their stake in the mortgage to Fannie or Freddie, move along, and go invest in other things. This helped more people get mortgages.

One concern was that Fannie and Freddie were simply too big and too concentrated. Another concern was that the federal government implicitly guaranteed investments in Freddie and Fannie, and that encouraged people to make home loans that were too risky.

Even without the complication of profits, the debate over how to reform Fannie and Freddie is at a stand still.

House Republicans don’t want the government involved at all, they want an efficient market. The Senate wants the government to be involved a little bit, essentially to promote housing.

“What I see,” says David Reiss, “is nothing really happening, and us being a holding pattern for a long time.”

It’s possible that reform-minded politicians will compromise before they lose their chance. Also possible they won’t.

Subprime Mortgage Conundrums

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Joseph Singer has posted Foreclosure and the Failures of Formality, or Subprime Mortgage Conundrums and How to Fix Them (also on SSRN). Singer writes,

One of the striking features of the subprime era is that banks acted without adequate regard for state property law. They were intent on serving the national and international financial markets with new and more profitable products, and they treated state property law as an obstacle to get around rather than a foundation on which to build. Rather than sell mortgages to families that could afford them, they hoodwinked the vulnerable by picking their pockets. Rather than honestly disclose the high risks associated with subprime loans, they paid rating agencies to give them AAA ratings, inducing investors to take risks they neither were prepared for nor understood. The banks made huge amounts of money marketing mortgages to people who could not afford to pay them back while offloading the risks of such deals onto hapless third parties. And rather than observe longstanding laws and customs designed to clarify property titles, banks evaded requirements of publicity and formality that traditionally governed real estate transactions. In short, the banks misled both borrowers and investors while undermining property titles. This was both a clever and a profitable way to engage in  business, but it was neither honorable nor responsible. (501, footnotes omitted)

Brad Borden and I have made a similar point in our debate with Joshua Stein, but Singer’s article plays it out in far greater depth. The article is a property prof’s cri de coeur over the near death of real property law principles during the early 2000s subprime boom, but it is also a very thorough inquest. The article concludes with a review of tools that are available to respond to failures in the mortgage market. All in all, it provides a nice overview of what led to the crisis as well as potential policy tools that are available to prevent future ones.