Tag Archives: freddie

Federal Government’s a Fairholme-weather Friend?

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Following up on my posts (here and here) about other suits against the federal government over its amendment of the terms of the distribution of dividends and other payments by Fannie Mae and Freddie Mac, I now look at Fairholme Funds, Inc. et al. v. FHFA et al., filed July 10, 2013.  The suit alleges very similar facts to those found in Fairholme Funds, Inc. v. United States, filed July 9, 2013, but the claims for relief are more similar to those found in Perry Capital, LLC v. Lew et al.

Here are some of the key claims made by the plaintiffs (owners of Fannie and Freddie preferred shares):

  • While the FHFA is the conservator of the two companies, it is acting acting like a receiver by “winding down” Fannie and Freddie’s “affairs and liquidating” their assets, while conservatorship should aim to return a company “to normal operation.” (15) The goal of the conservator, claim the plaintiffs, is to return the company “to a safe, sound and solvent condition.” (15, quoting Conservatorship and Receivership, 76 Fed. Reg. 35, 724, 35, 730(June 20, 2011)) As a result, plaintiffs argue that the Net Worth Sweep (which gives to the federal government substantially all of Fannie and Freddie’s profit) “is squarely contrary to FHFA’s statutory responsibilities as conservator of Fannie and Freddie” because it does not put them in “a sound and solvent condition” and it does not “conserve the assets and property” of the two companies. (25, quoting 12 U.S.C. section 4617(b)(2)(D))
  • “Neither Treasury nor FHFA made any public record of their decision-making processes in agreeing to the Net Worth Sweep.” (29) The plaintiffs argue that the FHFA’s “authority as conservator of” Fannie and Freddie “is strictly limited by statute.” (31, citing 12 U.S.C. section 4617(b)(2)(D)) As a result, the FHFA’s actions were “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” (33, quoting the APA, 5 U.S.C. section 706(2)(A))
  • The plaintiffs’ relationship with Treasury as Fannie and Freddie’s controlling shareholders is governed by state corporate law and thus Treasury owes “fiduciary duties to minority shareholders.” (38)
  • “Implicit in every contract is a covenant of good faith and fair dealing. The implied covenant requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.” (41) Plaintiffs argue that their contractual rights pursuant to their preferred shares have been breached by FHFA’s consent to the Net Worth Sweep.

The validity of these claims should not be assessed superficially. The courts will need to read HERA in the context of the APA and the amendment to the terms of the government’s preferred shares in the context of the contractual obligations found in the private preferred shares. The court will also need to assess the extent to which state corporate law governs the actions of the federal government when it is acting in the multiple capacities of lender, investor, regulator and conservator.  Let the memoranda in support and in opposition to motions to dismiss come forth and enlighten us as to how it should all play out . . ..

 

 

 

Fairholme or Foul? Investor Complaint Over Fannie and Freddie Preferred

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I recently reviewed the complaint filed by former Solicitor General Olson in Perry Capital LLC v. Lew and today I review the complaint in a similar lawsuit, Fairholme Funds, Inc. v. United States, filed July 9, 2013.  Fairholme filed another lawsuit the next day, Fairholme Funds, Inc. et al. v. FHFA et al., which I will review tomorrow. Whereas the Perry case alleged violations of the Administrative Procedures Act and the Housing and Economic Recovery Act of 2008 (HERA), the July 9th Fairholme case alleges that the United States must pay just compensations pursuant to the Fifth Amendment of the US Constitution for taking the plaintiffs’ property, by gutting Fannie Mae and Freddie Mac preferred shares of all of their worth.

As with the Perry case, the Fairholme complaint turns on whether an amendment to the government’s preferred stock documents which gave to the government all of Fannie and Freddie’s profits created a new security in violation of HERA.  In particular, the complaint alleges that by “changing the dividend on its Government Stock in this manner, FHFA actually created, and Treasury purchased, an entirely new security.” (5) This, it appears to me, is a highly contested claim.

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Evoking a famous Supreme Court case, the complaint also states that just “as the Federal Government cannot seize the assets of corporations (for example, the nation’s steel mills) for a public purpose without paying just compensation, so too it cannot seize the shares of stock in corporations to accomplish the same end.” (23) This implicit comparison to the Youngstown Steel case does not work as far as I am concerned.  In Youngstown Steel, the Supreme Court struck down President Truman’s exercise of his inherent authority to seize steel mills in order to support the Korean War mobilization.  Here, we have the federal government already knee deep in the affected companies.  Fannie and Freddie are government-sponsored enterprises; were placed in conservatorship; and have the federal government as their majority shareholders.

While the issues here are complex, my first read of the complaint is that the plaintiffs have a tough row to hoe even though the federal government may have upended preferred shareholders’ settled expectations.

Mortgage Bankers Ask Permission to Hijack GSE Reform

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The Mortgage Bankers Association issued a concept paper that calls for a board of mortgage industry representatives to “have the authority to direct the scope and immediate priorities of the [Central Securitization] Platform’s development, and the capability to redirect resources from the GSEs’ back offices to aid the project.” (3) So, to be clear, the mortgage industry wants not only to (a) define the scope and activities of the Platform but also (B) tell Fannie and Freddie how to spend their money to do so.  As Christmas is still a ways away, let’s spend some time working through this industry wishlist in the concept paper, The Central Securitization Platform: Direction, Scope, and Governance.

To start, what is the purpose of this mysterious “Platform?” According to the FHFA, it is supposed to “streamline and simplify those functions that are commoditized and routinely repeated across the secondary mortgage market.”(Building a New Infrastructure for the Secondary Mortgage Market, 5-6)

The MBA is calling for the establishment of “a strong panel of industry representatives to guide the development of the Platform.” (1)

But here is where I become nervous: “this Platform is just one piece of a much larger puzzle that impacts borrowers, lenders and the market as a whole. For these reasons, it is critical to appoint an industry advisory panel with real authority over the Platform’s early development. FHFA should establish and convene this panel before any further development is undertaken.” (2, emphasis added) Moreover, the MBA “believes the Platform should ultimately be owned by the industry as a cooperative.” (2)

So we have an acknowledgement that the Platform impacts “borrowers” and “the market as a whole.” But we have a call for a board with real powers that is only made up of “industry representatives.” Where have I heard a similar story like this before?  Oh, the Mortgage Electronic Recording System (MERS), a system designed by the mortgage industry that has been consistently attacked by local government officials and borrowers.

For now, I am agnostic as to whether the Platform is a good idea or not. But I certainly do not believe that only the industry should have the power to define its “scope and activities” and I certainly don’t believe that the industry should have the power to spend Fannie and Freddie’s money to pursue its vision. There are a lot more interests at stake than just the special interests represented by the MBA.

 

 

Where’s Perry? Are Phannie and Freddie Busted?!?

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With all apologies to Perry the Platypus who stars in my sons’ favorite TV show, Phineas and Ferb, today I look at the complaint in Perry Capital, LLC v. Lew et al. Perry Capital has sued the federal government for destroying the value of Fannie and Freddie securities held by Perry and the investment funds it manages. In particular, the complaint (drafted by Theodore Olson and others at Gibson Dunn) states that

Perry Capital seeks to prevent Defendants from giving effect to or enforcing the so-called Third Amendment to preferred stock purchase agreements (“PSPAs”) executed by Treasury and the FHFA, acting as conservator for the Companies. The Third Amendment fundamentally and unfairly alters the structure and nature of the securities Treasury purchased under the PSPAs, impermissibly destroys value in all of the Companies’ privately held securities, and illegally begins to liquidate the Companies. (2)

The plaintiff alleges that the government’s actions violate the Administrative Procedures Act (APA) and the Housing and Economic Recovery Act of 2008 (HERA). The APA governs the decision-making procedures of federal agencies like Treasury and independent agencies like the Federal Housing Finance Agency (FHFA). HERA was passed at the outset of the financial crisis and governs the process by which Fannie and Freddie may be put into conservatorship. (I discuss the enactment of HERA in Fannie Mae and Freddie Mac and the Future of Federal Housing Finance Policy: A Study of Regulatory Privilege, which is also available on BePress.)

[Warning:  necessary but complex details follow.  Those who are not GSE geeks may skip to the end.]

After the two companies were put into conservatorship in 2008,

Treasury and the FHFA executed the PSPAs, according to which Treasury purchased 1 million shares of the Government Preferred Stock from each company, in exchange for a funding commitment that allowed each company to draw up to $100 billion from Treasury as needed to ensure that they maintained a net worth of at least zero. As relevant here, the Government Preferred Stock for each company has a liquidation preference equal to $1 billion plus the sum of all draws by each company against Treasury’s funding commitment and is entitled to a cumulative dividend equal to ten percent of the outstanding liquidation preference. The PSPAs also grant Treasury warrants to purchase up to 79.9% of each company’s common stock at a nominal price. (2-3)

 According to the complaint, the Third Amendment to the PSPA changed the way that profits would be distributed by the two companies:

Under the original stock certificates, Treasury’s dividend was paid quarterly in the amount equal to an annual ten percent of the Government Preferred Stock’s outstanding liquidation preference. In the Third Amendment, the FHFA and Treasury amended the dividend provision to require that every dollar of each company’s net worth above a certain capital reserve amount be given to Treasury as a dividend. . . . Treasury’s additional profits from the Third Amendment are enormous. (5)

This is a very complex case, and I will return to it in future posts.  For now, I would just flag some issues that may pose problems for Perry.

First, is this case ripe for adjudication?  Perry states that they will be harmed when the two companies liquidate, but they are nowhere near liquidation.  Will the harm Perry predicts necessarily come about? The claim that they are harmed as to their expected dividends is stronger. Yet Perry acknowledges that the PSPAs “explicitly prohibit the payment of any dividend to any shareholder other than Treasury without Treasury’s consent.” (16)

Second, to what extent is this matter governed by the APA? I am not an APA expert, and I am wary of second-guessing Olson’s complaint in a blog post. But I would note that the court may not find that the APA even applies in this case and may find that HERA governs this dispute on its own. And even if the APA applies, the court may give great deference to the decisions of Treasury and the FHFA.

Finally, does the language from HERA that Perry relies on really give it much to hang its hat on? I think the crux of Perry’s argument is that the Third Amendment “created new securities”  instead of changing the terms of existing securities. (24) If a court disagrees with Perry on this (and it seems like a bit of a stretch to me), the theory of the case will be severely weakened.

All of this being said, I would agree with Perry that the holders of the Private Sector Preferred Stock — particularly the holders that predate conservatorship — look like they are receiving a raw deal from the federal government.  Various regulations encouraged lending institutions to hold Fannie and Freddie preferred stock over other investments. Those incentives sure looked like an implied guarantee before the subprime crisis knocked Fannie and Freddie off their feet.

Bottom line: this dispute cannot be settled in a late night blog post.  We’ll have to wait and see if Agent P can pull off what may be his most difficult mission yet.

Thrilla in Vanilla: Freddie v. Jumbo

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Kroll BondRatings issued an RMBS Commentary, Mortgage Credit Trends:  Freddie Mac vs. Prime Jumbo. This commentary is important because it offers some help in evaluating the proposed “risk sharing” securitizations that Fannie and Freddie are considering. It is also important because if compares plain vanilla agency issues with comparable private label jumbos as well as not-so-comparable limited doc jumbos.  The differences are revealing.

Kroll’s key findings are

  • Freddie Mac default and loss rates were much higher for vintages that experienced severe home price declines. The worst vintage was 2007, which experienced an estimated aggregate home price decline in excess of 18% with 12.3% of the original vintage balance liquidated to date.
  • A rapid and significant improvement in credit characteristics sharply curtailed Freddie Mac mortgage liquidation rates, which fell from 8.3% for the 2008 vintage to 0.9% for the 2009 vintage.
  • Current Freddie Mac originations continue to be of very high credit quality, with a weighted average (WA) FICO score of 767 and a WA loan-to-value ratio (LTV) of 70% for the 2012 vintage.
  • Credit performance of jumbo prime mortgages and Freddie Mac mortgages is highly comparable when controlling for characteristics such as FICO, LTV, balance, and income and asset documentation. (2)

I am most interested in the last finding. While Kroll controlled for many characteristics, the fact remained that Freddie, as a general rule, allows for fewer high risk characteristics like low doc loans and high CLTV [combined loan to value]. For instance, almost all of Freddie’s loans were full doc while about half of the private label loans were low doc. So, while Kroll appears to be correct in stating “that the credit analysis tools developed for analyzing jumbo prime loans can be productively applied to agency mortgages,” we should not take that to mean that the two products are effectively the same. (7)

 

State of the Nation’s Housing 2013: Build It and They Will Come

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The Joint Center for Housing Studies of Harvard University released The State of the Nation’s Housing 2013.  As always there is much of interest in this annual report. I was particularly intrigued by Figure 21 on page 20, “The Government Continues to Have an Outsized Footprint in the Mortgage Market.” The report states

Despite efforts to entice private capital into the mortgage market, the GSEs and FHA continue to back the vast majority of loans(Figure 21). In 2001, loans securitized into private-label securities or held in bank portfolios accounted for nearly half of loan originations. Their market share rose to about two-thirds at the height of the housing boom before retreating to the low single-digits. Beginning in 2009, government-backed loans have accounted for roughly 90 percent of all originations. While the private securities market was still moribund in 2012, portfolio lending by banks showed its first substantial increase in years (albeit to a modest level), bringing the government share down slightly. (20-21)

As Fannie and Freddie return to profitability, policymakers are acting as if only the government can provide credit to the residential mortgage market, but from Figure 21 we can see that over a relatively short time period, capital can meaningfully shift from the secondary market (private MBS) to the government (FHA, Fannie and Freddie) to the primary market (portfolio lenders). Instead of assuming that the present structure is the best of all possible worlds, we should design the system we want and incentivize capital to find it.

Build it and they will come.

FHFA: Critical Concerns Remain, Future Uncertain

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The FHFA issued its 2012 Report to Congress which provides a report of the annual examinations of Fannie, Freddie and the FHLBs. The report documents critical concerns about Fannie and Freddie, none of which are particularly newsworthy at this late date. But the report does have some intimations of what may lay ahead, which are particularly interesting now that the Senate has finally taken up GSE reform.

The report reviews the three goals set in 2012 for the ongoing conservatorship of Fannie and Freddie:

Build. Build a new infrastructure for the secondary mortgage market.
Contract. Gradually contract the Enterprises’ dominant presence in the marketplace while simplifying and shrinking their operations.
Maintain. Maintain foreclosure prevention activities and credit availability for new and refinanced mortgages. (1)

There are some interesting specifics attached to these general goals.

For the Build goal, FHFA has taken the position that there should be a new infrastructure for the secondary mortgage market that operates like a “market utility,” a model bandied about by Henry Paulson when he was Treasury Secretary. (13)

For the Contract goal, FHFA has indicated that it “will continue increasing guarantee fees in 2013  and evaluating how close current guarantee fee pricing is to the point where private capital would be willing to absorb credit risk.” 14)

For the Maintain goal, FHFA has taken the position that the mortgage market should transition to a more “competitive ” model, moving away from one in which “the government touches more than 9 out of every 10 mortgages.” (15)

While not surprising given Acting Director DeMarco’s past statements and actions, this report indicates that at least the FHFA believes that we should move away from such intense government involvement in the mortgage market to a system that better prices risk and which spreads that risk across a range of competitors. At such a high level of generality, I agree that these are worthwhile goals. But as with everything involving housing finance policy — the devil will be in the details.