Tag Archives: junior preferred

Fannie and Freddie Visit the Supreme Court

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Justice Gorsuch

Fannie and Fredddie investors have filed their petition for a writ of certiorari in Perry Capital v. Mnuchin. The question presented is

Whether 12 U.S.C. § 4617(f), which prohibits courts from issuing injunctions that “restrain or affect the exercise of powers or functions of” the Federal Housing Finance Agency (“FHFA”) “as a conservator,” bars judicial review of an action by FHFA and the Department of Treasury to seize for Treasury the net worth of Fannie Mae and Freddie Mac in perpetuity. (i)

What I find interesting about the brief is that relies so heavily on the narrative contained in Judge Brown’s dissent in the Court of Appeals decision. As I had noted previously, I do not find that narrative compelling, but I believe that some members of the court would, particularly Justice Gorsuch. The petition’s statement reads in part,

In August 2012—nearly four years after the Federal Housing Finance Agency (“FHFA”) placed Fannie Mae and Freddie Mac1 in conservatorship during the 2008 financial crisis—FHFA, acting as conservator to the Companies, agreed to surrender each Company’s net worth to the Treasury Department every quarter. This arrangement, referred to as the “Net Worth Sweep,” replaced a fixed-rate dividend to Treasury that was tied to Treasury’s purchase of senior preferred stock in the Companies during the financial crisis. FHFA and Treasury have provided justifications for the Net Worth Sweep that, as the Petition filed by Fairholme Funds, Inc. demonstrates, were pretextual. The Net Worth Sweep has enabled a massive confiscation by the government, allowing Treasury thus far to seize $130 billion more than it was entitled to receive under the pre-2012 financial arrangement—a fact that neither Treasury nor FHFA denies. As was intended, these massive capital outflows have brought the Companies to the edge of insolvency, and all but guaranteed that they will never exit FHFA’s conservatorship.

Petitioners here, investors that own preferred stock in the Companies, challenged the Net Worth Sweep as exceeding both FHFA’s and Treasury’s respective statutory powers. But the court of appeals held that the Net Worth Sweep was within FHFA’s statutory authority, and that keeping Treasury within the boundaries of its statutory mandate would impermissibly intrude on FHFA’s authority as conservator.

The decision of the court of appeals adopts an erroneous view of conservatorship unknown to our legal system. Conservators operate as fiduciaries to care for the interests of the entities or individuals under their supervision. Yet in the decision below, the D.C. Circuit held that FHFA acts within its conservatorship authority so long as it is not actually liquidating the Companies. In dissent, Judge Brown aptly described that holding as “dangerously far-reaching,” Pet.App. 88a, empowering a conservator even “to loot the Companies,” Pet.App. 104a.

The D.C. Circuit’s test for policing the bounds of FHFA’s statutory authority as conservator—if one can call it a test at all—breaks sharply from those of the Eleventh and Ninth Circuits, which have held that FHFA cannot evade judicial review merely by disguising its actions in the cloak of a conservator. And it likewise patently violates centuries of common-law understandings of the meaning of a conservatorship, including views held by the Federal Deposit Insurance Corporation (“FDIC”), whose conservatorship authority under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), served as the template for FHFA’s own conservatorship authority. Judge Brown correctly noted that the decision below thus “establish[es] a dangerous precedent” for FDIC-regulated financial institutions with trillions of dollars in assets. Pet.App. 109a. If the decision below is correct, then the FDIC as conservator could seize depositor funds from one bank and give them away—to another institution as equity, or to Treasury, or even to itself—as long as it is not actually liquidating the bank. The notion that the law permits a regulator appointed as conservator to act in a way so manifestly contrary to the interests of its conservatee is deeply destabilizing to our financial regulatory system. (1-2)

We shall see if this narrative of government overreach finds a sympathetic ear at the Court.

Reiss on Real Estate Cases To Watch In 2015

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Law360 quoted me in Real Estate Cases To Watch In 2015 (behind a paywall). It reads, in part,

As the real estate deals market has heated up, so have litigation dockets. And several cases with national or regional importance for developers and lenders on foreclosure practices, land use rights and housing finance reform are primed to see major developments in 2015, experts say.

A number of real estate cases wending their way through the court system – from state appeals courts to the U.S. Supreme Court – could affect how apartment owners, developers and lenders do business. And with the real estate market heating up, experts are also expecting a new wave of litigation to pop up in connection with an increasing pipeline of public-private partnership projects.

The cases are as varied as a high court suit that could throw open an avenue of Fair Housing Act litigation and a New Jersey matter that could give developers leverage to push forward on blocked projects. Here are a few cases and trends to watch in 2015:

*     *    *

Hedge fund Fairholme Capital Management LLC’s challenge to the government’s directing all the profits from Fannie Mae and Freddie Mac toward the U.S. Department of the Treasury has been closely watched for more than a year, and it is expected to come to a head in 2015.

The company alleges the government acted unconstitutionally when it altered its bailout deal for the government-sponsored enterprises to keep the companies’ profits for itself.

“If the plaintiffs win, it could have a dramatic impact on how housing finance reform plays out,” said David Reiss, a professor at Brooklyn Law School. “And even if they don’t win, the case can have a negative impact on housing finance reform if it casts a cloud over the whole project.”

Shareholders lost a related case in the D.C. district court, “but if they win the Fairholme case, things will get complicated,” Reiss said.

The case is Fairholme Funds Inc. v. U.S., case number 13-cv-00465, in the U.S. Court of Federal Claims.

Reiss on Shakespearean GSE Litigation

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Fundweb quoted me in Stateside: My Kingdom for a House. It reads in part,

History repeats itself. In 1483, Richard III seized the British crown from his 13-year-old nephew on a trumped up legal sophistry.  One justification was to prevent a return to the chaos of the War of the Roses, considered likely to resume under a child king. (Many historians believe he subsequently murdered those princes in the tower to dispense with future claims.)

Five centuries later, the issue of confiscation returns in the form of US government actions taken to stabilise the financial system during the 2008 credit crisis.  The usurpation argument repeats that the end justifies the means and the rule of law may be subverted in perceived emergencies for the common good. Recent legal cases are challenging that principle, with momentous long- term consequences for the nation.

Specifically, in 2008, Congress enacted the Housing Economic and Recovery Act, which authorised loans to mortgage agencies Fannie Mae and Freddie Mac known as government-sponsored entities. The HERA law placed the GSEs in a conservatorship, giving the US government senior preferred shares in the companies, which paid the government a 10 per cent dividend.

Eventually, the GSEs became immensely profitable again, having now repaid $30bn more to the government than the original loan. In 2012, the conservator passed a third amendment, which transformed the 10 per cent preferred dividend to a sweep of all profits, forever.

Richard Bove, vice-president equity research at Rafferty Capital Markets, responds: ”If the government has the right to override any contract and can appropriate private property for itself, then contracts mean nothing in the US and the government is like Richard III.”

Politics of populism
Ultimately, the government may determine whether the GSEs survive or in what guise or how their profits are distributed.

“Politicians are carrying out what people want them to do.  The public and the media maintain that if the bankers are harming society and the economy, there is no limitation on what the government can do,” says Bove. But beware. Investor confidence further erodes each time the government steps in to act unilaterally in the name of crisis control. The determinant is whether or not the country needs the GSEs to continue to underwrite mortgages and the answer is probably yes. Without them, there will be no one to under-write 30-year mortgages, “the monthly cost of owning a home will go up, prices will go down and it will kill housing in the US,” Bove insists.

Mel Watts, who was appointed this year as a new conservator, may represent a new direction for reshaping the GSEs. His recent speeches suggest he may be planning to merge the two agencies and liberate them from conservatorship status.

David Reiss, professor at Brooklyn Law School, points out another drawback to leaving the GSEs in limbo for six years. Executives, employees and others are now running for the exits, with turnover at the top. The agencies back 60 per cent of residential US mortgages but no longer know who they are. “It’s not healthy for homeowners or taxpayers,” says Reiss.

Investment War of the Roses
A number of hedge fund investors have rebelled, challenging the conservator’s behaviour. Marquee names include Perry Capital, Fairholme Funds and Pershing Square Capital Management. Their claims generally derive from assertions that the conservator illegally expropriated shareholder profits. The plaintiff hedge funds represent a motley crew, some of whom bought the stock after 2009, knowing they were picking up lottery tickets, and others well predating the conservatorship. From the sidelines, smaller investors watched keenly and joined the big boys’ ranks.

“People bought the stock only knowing that Icahn, Berkowitz and Ackmann had positions, so they followed like lemmings,” says Bove. To compound the confusion, most conventional wisdom from commentators lined up on one side. Many were openly remunerated by the shareholders, like New York University’s Richard Epstein.

Reiss adds that, “with no public speakers of equivalent prestige on the other side, it seemed inconceivable the investors might lose, which was a perfect set up for falling hard”.

Indeed they fell, with the recent ruling by Judge Royce Lamberth in the Perry hedge fund case.  The court dismissed the suit with complex arguments but one theme undergirded the judge’s ruling: the government had acted forcefully in a financial emergency, authorised by Congress, which he hesitated to unwind.

More on GSE Litigation

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Inside Mortgage Finance did a longer story on the GSE litigation that profiled my take on it, Expert: GSE Shareholder Suits at ‘Early Stage’ of a Long Process; Litigation No Barrier to Dissolution, Says Group.

Look for the various lawsuits filed by private owners of Fannie Mae and Freddie Mac stock against the federal government to take a “very long time to be decided,” as the courts may take up to a year to resolve just the introductory motions, according to a legal expert. Beyond that, the litigation over shares in the two government-sponsored enterprises could stretch out to the U.S. Supreme Court.

Brooklyn Law School Professor David Reiss, speaking during a Bloomberg Industries webinar last week, noted that lawsuits stemming from the savings and loan debacle of 20 years ago give a sense of the possible timeframe, but litigation brought by disenfranchised Fannie and Freddie investors against the government offers an entirely different and deeper set of legal complexities.

“These are factually and legally complex cases and don’t trust anyone who thinks this is a slam dunk for any one of the parties,” said Reiss. He added that neither the government nor shareholders of the two government-sponsored enterprises can cut a deal and settle for anything short of total victory.

“I think we have plaintiffs that are going to go all the way on this because they have a lot at stake and they have a lot of resources to pursue their claims. You have a government that doesn’t have an incentive to settle like a normal private party does. They’re not worried about litigation costs or time, so I foresee this going on for a very, very long time,” said Reiss.

More than a dozen lawsuits filed against the government – led by hedge funds Perry Capital and Fairholme Capital Management – are pending in federal district court in Washington, DC, and in the Court of Federal Claims. The shareholder plaintiffs allege that the Treasury’s 2012 change in the dividend structure of its preferred stock leaves no funds to pay dividends to junior shareholders.

The government in its pending motion to dismiss gives some clear indication as to the tactics it will take to derail the various shareholder suits, Reiss explained. The government’s brief states that not a single plaintiff is entitled to recover anything – either on their individual or derivative claims – in light of the extensive powers that the Housing and Economic Recovery Act vests in the Federal Housing Finance Agency in its capacity as conservator to the GSEs.

“Until we have some motions to dismiss decided, we’re not really going to know how wide a scope these cases will have,” he said. “Only when we having a ruling on a summary judgment motion, will we have a sense of the real issues in contention. I will say that we are at an absolutely early stage.”

With the “entire range of private, administrative and constitutional principles” due to be called into question through the litigation, Reiss said there’s a great deal of uncertainty how the courts will decide the issue, including whether the Supreme Court will hear the inevitable appeal by plaintiffs or the defendant.

Although the pending shareholder litigation and investors’ claims of a government taking “must be taken seriously,” there’s no barrier – either from a legal or safety and soundness standpoint – preventing Fannie and Freddie from being dissolved, the Heritage Foundation argued in an issue brief.

“Protecting property rights, however, does not mean that taxpayers and consumers must continue to be put at risk by these government-sponsored housing giants,” said Heritage. “The ongoing lawsuits need not impede and should not distract Congress from the critical task of dissolving these economically dangerous institutions.”

Each of the GSE charters explicitly grants Congress the power to dissolve the corporations free of any conditions. After dissolution, Heritage notes that creditors would be paid off, with any remaining assets divided among shareholders, taking into account the priorities of different classes of shares.

“Because the United States is a defendant in the lawsuits, the litigation can proceed independently of the GSEs’ dissolution,” said Heritage. “If shareholders prevail on their takings claim, or any other monetary claim, they would still be able to receive full restitution for any legitimate claims.”

Reiss on GSE Litigation

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Inside Mortgage Finance profiled me in Legal Expert: GSE Shareholder Plaintiffs, U.S. Want ‘Total’ Victory (behind a paywall). It reads,

Look for the various GSE shareholder lawsuits against the federal government to take a “very long time to be decided” with the courts taking up to a year to resolve just the introductory motions and an ultimate appeal to the U.S. Supreme Court.

That’s the view of one legal expert speaking during a recent Bloomberg Industries webinar on Fannie Mae and Freddie Mac litigation. Brooklyn Law School Professor David Reiss noted there are some parallels to the savings and loan lawsuits brought by owners against the federal government 20 years ago. But the attorney stressed that the litigation from the Fannie and Freddie investors against the government offers an entirely different and deeper set of legal complexities.

“These are factually and legally complex cases and don’t trust anyone that thinks this is a slam dunk for any one of the parties,” predicted Reiss. He added that neither the government nor GSE shareholders can cut a deal and settle for anything short of total victory.

In its motion to dismiss, the government argues that the plaintiffs – hedge funds that have speculated in the junior preferred – are not entitled to recover anything, either on their individual or derivative claims, in light of the extensive powers that the Housing and Economic Recovery Act granted to the Federal Housing Finance Agency in its capacity as conservator.

With the “entire range of private, administrative and constitutional principles” due to be called into question in this litigation, Reiss said there’s a great deal of uncertainty over how the courts will decide the issue, including whether the Supreme Court will hear the inevitable appeal by plaintiffs or defendant.

Reiss in Bloomberg Industries Q&A on Frannie Litigation

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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

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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.