Hope for GSE Shareholders

Judge Lamberth issued an opinion in Fairholme Funds, Inc. v. FHFA (Civ. No.13-1439) (Sept. 28, 2018) that gives some hope to the private shareholders of Fannie Mae and Freddie Mac. These shareholders have been on the losing end of nearly every case brought against the government relating to its handling of the conservatorships of the two companies.  Readers of this blog know that I have long been a skeptic of the shareholders’ claims because of the broad powers granted the government by the Housing and Economic Recovery Act of 2008, passed during the height of the financial crisis, as well as the highly regulated environment in which the two companies operate. This highly regulated environment means that GSE profits are driven by regulatory decisions much more than those of other financial institutions. As such, Fannie and Freddie live and die by the sword of government intervention in the mortgage market.

Judge Lamberth had dismissed the plaintiffs’ claims in their entirety, but was reversed in part on appeal. In this case, he revisits the issues arising from the reversal of his earlier dismissal. Once again, Judge Lamberth dismisses a number of the plaintiffs’ claims, but he finds that that their claim that the government breached the duty of good faith survives.

The opinion gives a road map that shareholders can follow to success. The judge identifies allegations that, if true, would be a sufficient factual basis for a holding that the government breached the implied covenant of good faith and fair dealing. It is plausible that the preponderance of proof may support these allegations. Some evidence has already come to light that indicates that at least some government actors had good reason to believe that Fannie and Freddie were on the cusp of sustained profitability when the government implemented the net worth sweep. The net worth sweep had redirected the net profits of the two companies to the U.S. Treasury.

Judge Lamberth highlights some of aspects of the plaintiffs’ argument that he found compelling at the motion to dismiss phase of this litigation. First, he notes that absence of “any increased funding commitment” is atypical when senior shareholders receive “enhanced disbursement rights,” as was the case when the government implemented the net worth sweep. (21) He also states that the plaintiffs would not have expected that the GSEs would have extinguished “the possibility of dividends arbitrarily or unreasonably.” (22)

While this opinion is good news for the plaintiffs, it is still unclear what their endgame would be if they were to get a final judgment that the net worth sweep was invalid. Depending on the outcome of regulatory and legislative debates about the future of the two companies, the win may be a pyrrhic one. Time will tell. In the interim, expect more discovery battles, motions for summary judgment and even a trial in this case. So, while this opinion gives shareholders some hope of ultimate success, and perhaps some leverage in political and regulatory debates, I do not see it as a game changer in itself.

In terms of the bigger picture, there are a lot of changes on the horizon regarding the future of the housing finance system. The midterm elections; Hensarling and Corker’s departure from Congress; and the Trump Administration’s priorities are all bigger drivers of the housing finance reform train, at least for now.

Reiss in Bloomberg Industries Q&A on Frannie Litigation

Bloomberg Industries Litigation Analyst Emily Hamburger interviewed me about The Government as Defendant: Breaking Down Fannie-Freddie Lawsuits (link to audio of the call). The blurb for the interview is as follows:

As investors engage in jurisdictional discovery and the government pleads for dismissals in several federal cases over Fannie Mae and Freddie Mac stock, Professor David Reiss of Brooklyn Law School will provide his insights on the dynamics of the lawsuits and possible outcomes for Wall Street, the U.S. government and GSEs. Reiss is the author of a recent article, An Overview of the Fannie and Freddie Conservatorship Litigation.

Emily questioned me for the first half of the one hour call and some of the 200+ participants asked questions in the second half.

Emily’s questions included the following (paraphrased below)

  • You’re tracking several cases that deal with the government’s role in Fannie Mae and Freddie Mac, and I’d like to go through about 3 of the major assertions made by investors – investors that own junior preferred and common stock in the GSEs – against the government and hear your thoughts:
    • The first is the accusation that the Treasury and FHFA’s Conduct in the execution of the Third Amendment was arbitrary and capricious. What do you think of this?
    •  Another claim made by the plaintiffs is that the government’s actions constitute a taking of property without just compensation, which would be seen as a violation of the 5th Amendment – do you think this is a stronger or weaker claim?
    • And finally – what about plaintiffs asserting breach of contract against the government? Plaintiffs have said that the Net Worth Sweep in the Third Amendment to the Preferred Stock Purchase Agreement nullified Fannie and Freddie’s ability to pay dividends, and that the two companies can’t unilaterally change terms of preferred stock, and that the FHFA is guilty of causing this breach.
  • Is the government correct when they say that the section 4617 of the Housing and Economic Recovery Act barred plaintiff’s right to sue over the conservator’s decisions?
  • Former Solicitor General Theodore Olson, an attorney for Perry Capital, has said that the government’s powers with respect to the interventions in Fannie and Freddie “expired” – is he correct?
  • Can you explain what exactly jurisdictional discovery is and why it’s important?
  • Do we know anything about what might happen if one judge rules for the plaintiffs and another judge rules for the government?
  • Is there an estimate that you can provide as to timing?
  • Are there any precedents that you know of from prior crises? Prior interventions by the government that private plaintiffs brought suit against?
  • How do you foresee Congress and policymakers changing outcomes?
  • What do we need to be looking out for now in the litigation?
  • How does this end?

You have to listen to the audiotape to hear my answers, but my bottom line is this — these are factually and legally complex cases and don’t trust anyone who thinks that this is a slam dunk for any of the parties.

 

Reiss on Bloomberg Terminals regarding GSE Litigation

I was quoted on the Bloomberg Terminals (behind a very expensive paywall!) on May 6th about the Fannie and Freddie litigation:

Even if the Junior Preferred Shareholders get the Court to void the Third Amendment to the PSPA, they cannot force the companies to issue dividends so that shareholders receive a payoff. And if the government were to lower the guarantee fee that the two companies can charge or if it were to remove the government’s guarantee of the two companies, Fannie and Freddie’s profits would dissipate altogether.

Given that junior preferred shareholders have developed a multi-pronged strategy to squeeze as much value out of their shares as possible, it is worth attempting to determine the possible endgames that they have in mind. It is hard for me to identify a litigation outcome that results in money in their pockets for the reasons stated above. So the litigation strategy must be part of a broader strategy that involves lobbying over housing finance reform in Congress, lobbying the FHFA and other regulators or negotiating with the two companies. Given the amount of money at stake and the depth of the pockets of the junior preferred shareholders, one can imagine that they are playing a very long-term game, one that might last longer than all of the current decision-makers in DC right now. Some disputes arising out of the S&L crisis took many, many years to resolve so there is reason to think that the junior preferred shareholders have a multi-year or even decades-long perspective on this. And the farther away we are from the events of the 2000s and the emotions that they elicit from decisionmakers, the more likely it is that the junior preferred shareholders can negotiate a favorable result for themselves.

Fannie and Freddie’s Debt to Treasury

Larry Wall of the Federal Reserve Bank of Atlanta has posted one of his Notes from the Vault, Have the Government-Sponsored Enterprises Fully Repaid the Treasury? It opens,

Have U.S. taxpayers been fully compensated for their bailout of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac? The Treasury is reported to have argued that “the value of Treasury’s commitment to the GSEs was “incalculably large,'” with the implication that it could never be repaid. Richard Epstein, the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution [and who discloses that he consults “with several hedge funds with positions in Fannie and Freddie”], responded that “the level of the Treasury commitment was not ‘incalculably large’: it was $188 billion, all of which will shortly be repaid.” The significance of Epstein’s argument is that if Treasury has been fully compensated for its bailout of Fannie and Freddie, a case can be made that the future profits of the two GSEs should go to their private shareholders.

As an accounting matter, one could argue that Epstein is correct; the dividends equal the amount of Treasury funds provided to the GSEs. And as a legal matter, the issue may ultimately be resolved by the federal courts. However, as an economic matter, the value of the government’s contribution clearly exceeds $188 billion once the risk borne by taxpayers is taken into account.

In this Notes from the Vault I examine the value of the taxpayers’ contribution to Fannie and Freddie from an economic perspective. My analysis of these contributions is divided into three parts: (1) the GSEs’ profitability prior to the 2008 conservatorship agreement (bailout), (2) the value of the taxpayer promise at the time of the bailout, and (3) support of new investments since they were placed in conservatorship. (1)

The article goes on to explain each of these three parts of the taxpayers’ contribution and concludes,

The claim that the taxpayers and Treasury have been fully repaid for their support of Fannie Mae and Freddie Mac is based on an accounting calculation that does not withstand economic analysis. The claim that Treasury’s commitment has been fully repaid attributes no dividend payments to Treasury starting in 2012, attributes no value to the government guarantee to absorb whatever losses arose in the pre-conservatorship book of business, and arguably reflects Treasury setting too low of a dividend rate on its senior preferred stock. Moreover, the profits that are being used to pay the dividends did not arise from the contributions of private shareholders but rather entirely reflect risks borne by the Treasury and taxpayers. Thus, the Treasury claim that the value of the aid was “incalculable” is an exaggeration; the value surely can be fixed within reasonable bounds. However, the implication of this claim, that the GSEs cannot repay the economic value on behalf of their common shareholders, is nevertheless accurate. (2)

This article offers a useful corrective to the story one hears from those representing Fannie and Freddie’s shareholders. They have constructed a simple narrative of the bailout of the two companies that ignores the way that the two companies’ fortunes have been intrinsically tied to the federal government’s support of them. That simple narrative just nets out the monies that Treasury fronted Fannie and Freddie with the payments that the two companies made back to Treasury.  After netting the two, they say, “Case closed!” Wall has demonstrated that there are a lot more factors at play than just those two.

I would also highlight something that Wall did not: the federal government actually determines the level of profits that Fannie and Freddie can make by setting the fees the two companies charge for guaranteeing mortgages. So, the federal government could wipe away future profits by lowering the guaranty fees. And wiping away those profits would make those outstanding shares worthless.

So the question remains: what is the endgame for the investors who have brought these lawsuits?