Tag Archives: junior preferred

Reiss on Hedge Funds’ GSE Strategy

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American Banker quoted me in Everything Lenders Need to Know About GSE Shareholders’ Lawsuits (behind a paywall, but available in full here). It reads in part,

A powerful group of shareholders is amplifying attacks on housing finance reform legislation as they await resolution of a major legal battle, attempting to slow momentum on the bill before it likely passes the Senate Banking Committee.

Several big hedge funds that stand to possibly win billions of dollars for their shares in Fannie Mae and Freddie Mac are leading the charge, both in federal court and in the court of public opinion.

New investors’ rights groups said to be backed by the funds have popped up in recent weeks attacking legislation by Sens. Tim Johnson, D-S.D., chairman of the Senate Banking Committee, and Mike Crapo, the panel’s top Republican.

Their presence is yet another complicating factor in the tumult ahead of a scheduled April 29 vote by the committee, potentially hurting efforts to secure additional support for the measure.

“Now that different people have come out with their bills, it’s been laid bare that the people working on [government-sponsored enterprise] reform aren’t going to do major favors for the shareholders,” said Jeb Mason, a managing director at Cypress Group. “As a result, the shareholders have adjusted their strategy to muddy the waters – and, if they can, kill the Johnson-Crapo bill.”

*     *     *

As part of their effort, investors have begun taking their concerns public through new tax-exempt groups in Washington. The investors argue they were on the receiving end of a rotten deal from the government, particularly those that bought the stocks before the enterprises were put into conservatorship.

“The hedge funds have this incredibly sophisticated, multi-pronged strategy – lawsuits, legislation, academics on the payroll, funding anonymous PR campaigns, offering to buy the companies. They’re coming at it from all angles,” said David Reiss, a professor at Brooklyn Law School.

*     *     *

Given the size and complexity of the cases, it’s likely to take years before the matter is resolved entirely. Analysts have suggested that if both sides continue to push the issue, it could even rise up to the Supreme Court over the next several years.

“You’re talking about many-year or potentially, decades-long lawsuits,” said Reiss. “The stakes are humongous and the parties are incredibly sophisticated and well financed. The government parties’ incentives to settle are not the same as a private party – I could imagine them seeing this all the way through.”

GSE Litigation Through Corporate Law Lens

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Adam Badawi and Anthony Casey have posted The Fannie and Freddie Bailouts Through the Corporate Lens to SSRN. The paper takes a look at the bailouts as if they were simple insolvent private firms. This is a helpful thought experiment even though the two federally chartered and heavily regulated firms are anything but simple, private firms. They write that while it is politically controversial to wipe out the shareholder equity in the two firms, doing so

is consistent with what often happens to stockholders of distressed companies. Indeed that is the more likely outcome when a corporation is sold or reorganized under Chapter 11 of the Bankruptcy Code. There remains little doubt that the Entities [Fannie and Freddie] were highly distressed at the time of the PSPAs [Preferred Stock Purchase Agreements] and Amendments [to the PSPAs]. Thus, while procedurally suspect, these actions did not substantively violate the norms of corporate law and finance that would apply to private companies in the same position. To the contrary, in the private context there may have been no action available that would have legally allocated any future interest in the Entities to the (junior) preferred and common shareholders. (1, footnotes omitted)

They add, that in “the private context, there would have been pressure to file for bankruptcy to liquidate the assets and eliminate the risk to creditors. And once in bankruptcy, the directors would have been entirely barred from taking actions to benefit equity at the expense of creditors.” (3) And they conclude that “the substance of Treasury’s and the Entities’ actions – in September 2008 and August 2012 – were generally in line with acceptable actions of creditors and debtors involved in restructuring distressed corporations in Chapter 11 bankruptcy or in out-of-court reorganizations.” (3-4)

I could excerpt selection after selection, but instead, I recommend that you read this interesting paper for yourself!

Tough Row to Hoe for Frannie Shareholders

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Inside Mortgage Finance quoted me in a story, GSE Jr. Preferred Shareholders Have a Tough ‘Row to Hoe’ in Winning Their Lawsuits (behind a paywall). It reads,

Expect a long and winding legal road to resolution of investor lawsuits challenging the Treasury Department’s “net worth sweep” of Fannie Mae and Freddie Mac earnings, warn legal experts.

More than a dozen lawsuits filed against the government – including 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 private equity plaintiffs allege that the Treasury’s change in the dividend structure of its preferred stock leaves the government-sponsored enterprises with no funds to pay anything to junior shareholders.

The complaints raise complex constitutional and securities law issues, according to Emily Hamburger, a litigation analyst for Bloomberg Industries. “It may be a year before the crucial questions can be answered by the courts because the parties are still in the early stages of gathering evidence,” explained Hamburger during a recent webinar.

Brooklyn Law School Professor David Reiss agrees. “The plaintiffs, in the main, argue that the federal government has breached its duties to preferred shareholders, common shareholders, and potential beneficiaries of a housing trust fund authorized by the same statute that authorized their conservatorships. At this early stage, it appears that the plaintiffs have a tough row to hoe,” notes Reiss in a draft paper examining the GSE shareholder lawsuits.

Government attorneys argue that Treasury has authority to purchase Fannie and Freddie stock when it’s determined such actions are necessary to provide stability to the financial markets, prevent disruptions in the availability of mortgage finance and protect the taxpayer. The government also argues that the plaintiffs do not have a legal property interest for purposes of a Fifth Amendment “takings” claim due to the GSEs’ status in conservatorship.

Hamburger predicted that the judges in the various suits won’t be able to ignore the “obvious equitable tensions” involved. “The government is changing the terms years after their bailout, but on the other hand, the timing and motivation of investors is going to be challenged too,” she noted.

While Reiss agrees that the junior shareholders “look like they are receiving a raw deal from the federal government,” it’s a tall order to sue the federal government even under the most favorable of circumstances. The plaintiffs will have to overcome the government’s sovereign immunity, unless it is waived, and the government has additional defenses, including immunity from Administrative Procedures Act claims, under the Housing and Economic Recovery Act of 2008.

Reiss explained that HERA states that except “at the request of the Federal Housing Finance Agency, no court may take any action to restrain or affect the exercise of powers or functions of [FHFA] as conservator or receiver.” It remains to be seen how this language might apply to Treasury’s change in the preferred stock agreement, but Reiss said it could be read to give the government broad authority to address the financial situation of the two companies.

“The litigation surrounding GSE conservatorship raises all sorts of issues about the federal government’s involvement in housing finance,” said Reiss. “These issues are worth setting forth as the proper role of these two companies in the housing finance system is still very much up in the air.”

The full paper, An Overview of the Fannie and Freddie Conservatorship Litigation (SSRN link), can also be found on BePress.

Fannie and Freddie’s Debt to Treasury

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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?