Tag Archives: conflict of interest

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.

S&P on Rating Mortgage-Backed Securities Before The Crisis

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S&P has posted The Role of Credit Rating Agencies in The Financial System, remarks by its president at the United Nations. The remarks reflect S&P’s narrative of the events leading up to the Subprime Crisis. This narrative is, unsurprisingly, self-serving but revealing nonetheless.

  • We, like others, did not anticipate the U.S. housing downturn, which led to the financial crisis. But with the exception of our ratings on U.S. mortgage-related securities, our ratings have performed as expected. (3) 

Seems like a perfect example of the exception swallowing the rule . . ..

  • In September of 2008, we were all in the depths of the financial crisis. During that time the vast majority of the securities S&P rated performed as we anticipated, including many structured finance ratings. But the performance of our ratings of certain U.S. residential mortgage-related securities was a major disappointment. Like nearly every other market participant, analyst and interested government entity, we did not anticipate the U.S. housing collapse and its effect on the economy as a whole. (4)

As I have said before, this is self-serving revisionism, when S&P’s own analysts predicted the collapse of many of the mortgage-backed securities that they rated before the Bust.

  • We have taken significant actions to further strengthen our independence from issuer influence. We have long had policies to manage potential conflicts of interest such as a separation of analytic and commercial activities, a ban on analysts from participating in fee negotiations, and de-linking analyst compensation from the volume of securities they rate or the type of ratings they assign. After the crisis, we decided to strengthen analytical independence by rotating the analysts assigned to a particular issuer and enhancing analyst training. (4)

No mention here of the fact that their longstanding policies appeared to have not been up to the task of controlling for conflicts as far as anyone was concerned . . ..

  • For mortgage-related securities, for example, we significantly increased the credit enhancement required to achieve a ‘AAA’ rating and made it more difficult for securities to achieve high ratings. (4)

Thank goodness for that! Time will tell if these new assumptions adequately reflect the risk of default for complex MBS.

SEC To Focus on Structured Finance Ratings

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A SEC staff study looks at three ways to reform the manner in which ratings are produced for structured finance securities.

The study, required by Dodd-Frank, addresses

(1) The credit rating process for structured finance products and the conflicts of interest associated with the issuer-pay and the subscriber-pay models;

(2) The feasibility of establishing a system in which a public or private utility or a self-regulatory organization (“SRO”) assigns NRSROs to determine the credit ratings for structured finance products, including:

(a) An assessment of potential mechanisms for determining fees for NRSROs for rating structured finance products;
(b) Appropriate methods for paying fees to NRSROs to rate structured finance products;
(c) The extent to which the creation of such a system would be viewed as the creation of moral hazard by the Federal Government; and

(d) Any constitutional or other issues concerning the establishment of such a system;5

(3) The range of metrics that could be used to determine the accuracy of credit ratings for structured finance products;6 and
(4) Alternative means for compensating NRSROs that would create incentives for accurate credit ratings for structured finance products.