AIG’s “Victory” and the GSE Litigation

AIG_Headquarters_New_York_City

Court of Federal Claims Judge Wheeler issued an Opinion and Order in Starr International Company, Inc. v. United States, No. 11-779C (June 15, 2015), the case that Hank Greenberg brought against the government over the terms of the bailout of AIG during the financial crisis. The judge found that the government exceeded its authority in taking an equity interest in AIG, but did not award the plaintiffs any damages.  Many will read the tea leaves of this opinion to see what they tell us about the litigation brought against the federal government by shareholders in Fannie and Freddie arising from the bailout of those two companies. I think it offers little guidance as to liability but lots as to damages.

My most important takeaway from the opinion (which seems well-reasoned to me) is that the holding is based on a close reading of the Federal Reserve Act.  The Act enumerates the powers and limitations of the Fed.  The Court held that the Act does not authorize the Fed to take equity in a company as part of a bailout.

Fannie and Freddie are regulated by the Federal Housing Finance Administration (FHFA). The FHFA’s powers and limitations, in contrast, derive from the Housing and Economic Recovery Act of 2008 (HERA), passed during the financial crisis itself.  HERA explicitly granted the FHFA broad powers as conservator.  Section 1117 of HERA authorized the Secretary of the Treasury to make unlimited equity and debt investments in the two companies’ securities through December 31, 2009.  (There is a disagreement as to whether the the Third Amendment to the Preferred Stock Purchase Agreement, discussed here, created new securities after that date, but the more general point is that HERA authorized equity investments in a way that the Federal Reserve Act did not.)

In sum, I would not read too much into the GSE litigation from the AIG litigation as it relates to the government’s ability to take equity in Fannie and Freddie.  The two cases arise under two completely different statutes.

As to the damages component of the opinion, there are many cases when a court finds for a plaintiff but only awards nominal damages.  Thus, the Court’s opinion is not particularly out of the ordinary in this regard.  Here, the Court relied on the reasoning of the Court of Appeals for the Federal Circuit in a TARP case, A&D Auto Sales, Inc. v. United States, 748 F.3d 1142 (Fed. Cir. 2014).  In that case, the Federal Circuit found that absent allegations that “GM and Chrysler would have avoided bankruptcy but for the Government’s intervention and that the franchises would have had value in that scenario,” there was no basis to argue that the government caused “a net negative economic impact” on the plaintiffs (Starr at 66, quoting A&D at 1158).

It would appear that to prove damages, the GSE litigation plaintiffs will need to overcome that bar too, even if they were to succeed in proving that the government had acted improperly in bailing out Fannie and Freddie.

Be Careful What You Wish For GSEs

Genie Lamp

Jim Parrott and Mark Zandi have released a report, Privatizing Fannie and Freddie: Be Careful What You Ask For. The authors go through a very useful exercise in which they break down the cost of reprivatizing. The report opens,

Few are happy with the current housing finance system that has Fannie Mae and Freddie Mac in conservatorship and taxpayers backing most of the nation’s residential mortgage loans. Yet legislative efforts to replace the system have largely faltered, raising concern that we may not have the political will or competence to replace it any time soon.

This has created an opening for those who contend that we should not replace the system at all, but simply recapitalize the government-sponsored enterprises and release them from conservatorship. Fannie and Freddie were remarkably profitable prior to the financial crisis, after all, and have been consistently in the black recently. Why embark on the laborious, risky and now stalled process of fundamental reform when we can simply return to a model that we know can provide steady access to affordable, long-term fixed-rate lending?

While we both have serious concerns with the wisdom of releasing the duopoly back into the market, we thought it useful to set those concerns aside for the moment to explore the economics of the move. The discussion often takes for granted that this path would take us back to the world precrisis, but economic conditions and the regulatory environment have changed in ways that would significantly affect how Fannie and Freddie would function as reprivatized institutions. (2)

Parrott and Zandi conclude that

The debate over whether to recapitalize and release the GSEs into the private market is often framed as a choice of whether or not to return to a prior period in lending. For all its shortcomings, the argument goes, at least we know what to expect in the cost and availability of mortgage credit. But this is a misconception. In releasing the GSEs into the private market again, we would release them into a very different regulatory and economic environment, and they would respond, not surprisingly, by charging very different mortgage rates. (4)

I really have no argument with Parrott and Zandi’s paper, but I would note that their conclusions don’t differ so much from the pre-crisis academic papers that attempted to quantify the increase in mortgage rates that would result from privatizing the two companies — fifty basis points, give or take (see, for example, The GSE Implicit Subsidy and Value of Government Ambiguity).

I value Parrott and Zandi’s paper because it reminds us to keep pushing forward with real housing finance reform even though Congress has not yet made any progress on that front.

Reiss on SCOTUS Junior Lien Decision

US-Supreme-Court-room-SC

Bloomberg BNA quoted me in Nagging Economic and Credit Questions Dampen Bankruptcy Victory for Bankers (behind paywall). It reads, in part:

The U.S. Supreme Court delivered an important bankruptcy ruling for bankers that doesn’t, however, do anything about still-struggling homeowners (Bank of Am. N.A. v. Caulkett, 2015 BL 171240, U.S., No. 13-cv-01421, 6/1/15); (Bank of Am. N.A. v. Toledo-Cardona, 2015 BL 171240, U.S., No. 14-cv-00163, 6/1/15).

In a June 1 decision, the court said Chapter 7 debtors cannot void junior liens on their homes when first-lien debt exceeds the value of the property, as long as the senior debt is secured and allowed under the Bankruptcy Code.

The decision is a victory for Bank of America, which held both junior liens in the two related cases, and for banking groups that said a different result could have destabilized more than $40 billion in commercial loans secured by similar liens.

But Brooklyn Law School Professor David Reiss June 2 said the case highlights the need for a broad remedy for homeowners who have continued to struggle to make payments since the financial crisis.

“The bank’s position as a legal matter is a very reasonable one, but from a policy perspective we needed and still need a bigger and more systemic solution to the problems that households face,” Reiss told Bloomberg BNA.

*     *     *

[S]ome said the ruling highlights economic questions on several levels.

Reiss, who coedits a financial blog, June 2 said the case shows the federal government’s inability to deal head-on with the impact of financial turmoil in 2008 and 2009.

“Not enough is being done to move households beyond the crisis, and it’s bad for households and it’s bad for the financial sector,” Reiss said. “Here we are seven or eight years later and we’re sitting here with these valueless second mortgages. We’re just slogging through the muck and we’re not coming up with any good solutions to get past it.”

Seeking Justice Through Litigation

AbandonedHouseDelray

Judge Caproni (SDNY) issued an Opinion and Order in Adkins v. Morgan Stanley, No. 12-CV-7667 (May 14, 2015). It opens,

This is one of many cases arising out of the collapse of the housing market. This one comes with a twist: homeowners in Detroit who received subprime loans seek to hold a single investment bank responsible under the Fair Housing Act (“FHA”) for discriminating against African-American borrowers, based on their claim that African-Americans were more likely than similarly-situated white borrowers to receive so-called “Combined-Risk loans.” Plaintiffs allege that Morgan Stanley so infected the market for residential mortgages — and for mortgages written by New Century Mortgage Company, a now defunct loan originator, in particular — that it bears responsibility for the disparate impact of New Century’s lending practices. Although Plaintiffs advance creative theories, their class action lawsuit founders on the requirements of Federal Rule of Civil Procedure 23. (1-2, footnote omitted)

Judge Caproni notes that she is “not unsympathetic to Plaintiff’s claims,” she concludes that this class action lawsuit is an inappropriate vehicle to rectify the wrong that Plaintiffs allege Morgan Stanley perpetrated.” (2) I am not an expert on the law of class actions, but the opinion does seem to identify a number of ways in which the proposed class is “unworkable.” (2)

We are now nearly ten years in from the start of the financial crisis and it seems like we can get a broad sense of whether justice has been served.  My instinct is that many people would say “No,” a resounding “No!”

At first glance that might seem odd, particularly to the shareholders and management of financial institutions who have paid tens of billions of dollars in fines and judgments. But there is a strong sense that those who have been harmed have not been able to get their day in court with those who did the harming. A case like this reveals the limitations of litigation as a means for seeking justice. Not every injustice is capable of being remedied in a court of law.

What does this tell us about preparing for the aftermath of the next crisis? How can laws be changed now to ensure that the right people and institutions are held accountable when it hits? While there are no easy answers to these questions, lawmakers should consider whether the scope of organizational liability is properly defined, whether agents of organizations are properly held accountable and whether organizations working in tandem with each other can be properly held accountable for the harms that they cause collectively. Easier said than done, I know, but still worth the effort.

Gen X & Millennial Renters

Gen X

Jason Michael

MainStreet quoted me in Generation X and Millennials Are Choosing to Remain Renters. It opens,

Although James Crosby is getting married later this year to his college sweetheart, the financial analyst said they do not have plans to buy a home in Atlanta in the next few years.

While Crosby, who is 25, said he loathes paying rent and not building up equity in a home, renting has its benefits. Right now, it’s easy for him to budget for rent in an apartment, because the amount he pays each month is static and he will not be faced with any costly surprises such as repairing an air conditioner.

Like Crosby, fewer Americans are drawn to owning a home and plan to keep renting as wages remain stagnant and home prices have risen. A recent Gallup poll found that many people are content to be renters with 41% of non-homeowners who said they do not plan to purchase a home in “the foreseeable future.” The gap is widening since only one of three people agreed with this sentiment two years ago. The percentage of people who own homes has dropped to 61%, which is the lowest figure in almost 15 years, the poll revealed.

Tepid Economy Plays a Factor

Both the desire and ability to buy a house is waning among some individuals, because “the economy has kept young people from forming their own households as quickly as they had before the financial crisis,” said David Reiss, a law professor at Brooklyn Law School.

Some Gen X-ers and Millennials are also living at home longer than previous generations and wind up deferring homeownership. The weak and soft job markets have impacted Millennials who are also faced with carrying a heavy debt load from having to finance their undergraduate degrees.

“I would predict that if the economy warms up for a reasonable time, expectations about homeownership are likely to change quickly,” Reiss said.

FHFA’s $500MM Win

Bloomberg quoted me in Nomura, RBS Defective-Bond Suit Loss Seen Spurring Deals. It reads, in part,

Nomura Holdings Inc. and Royal Bank of Scotland Group Plc may face $500 million in damages for what a judge called an “enormous” deception in the sale of defective mortgage-backed securities, a ruling that may spur other banks to settle similar claims tied to the 2008 financial crisis.

Nomura and RBS were excoriated in a 361-page opinion by U.S. District Judge Denise Cote in Manhattan, whose ruling followed the first trial of claims that banks sold flawed securities to government-owned mortgage companies. After a three-week trial, Cote said they misled Fannie Mae and Freddie Mac and set a damages formula that may result in the government winning about half its original claim of $1 billion.

“The offering documents did not correctly describe the mortgage loans,” Cote, who heard the case without a jury, wrote Monday. “The magnitude of falsity, conservatively measured, is enormous.”

Before the trial, FHFA had reached $17.9 billion in settlements with other banks, including Bank of America Corp., JPMorgan Chase & Co. and Goldman Sachs Group Inc. The ruling against Nomura and RBS may encourage other banks to settle mortgage-related suits brought by regulators and private investors rather than face the bad publicity and cost of an adverse judgment, said Robert C. Hockett, a professor at Cornell Law School.

“They look pretty bad,” Hockett said in an interview. “They look like the strategy has blown up in their faces.”

Cote ordered the Federal Housing Finance Agency, which filed the case, to propose how much the banks should pay as a result of her ruling.

*     *     *

Cote rejected the banks’ claim that the housing crash, and not defects in the loans, was responsible for the collapse of the mortgage-backed securities.

David Reiss, a professor at Brooklyn Law School, called Cote’s ruling “incredibly thorough.” The judge included detailed factual rulings that may make it difficult for Nomura and RBS to win on appeal, he said.

Friday’s Government Reports Roundup