Tag Archives: Preferred Stock Purchase Agreement

Regulating Fannie and Freddie With The Deal

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Steven Davidoff Solomon and David T. Zaring have posted After the Deal: Fannie, Freddie and the Financial Crisis Aftermath to SSRN. The abstract reads,

The dramatic events of the financial crisis led the government to respond with a new form of regulation. Regulation by deal bent the rule of law to rescue financial institutions through transactions and forced investments; it may have helped to save the economy, but it failed to observe a laundry list of basic principles of corporate and administrative law. We examine the aftermath of this kind of regulation through the lens of the current litigation between shareholders and the government over the future of Fannie Mae and Freddie Mac. We conclude that while regulation by deal has a place in the government’s financial crisis toolkit, there must come a time when the law again takes firm hold. The shareholders of Fannie Mae and Freddie Mac, who have sought damages from the government because its decision to eliminate dividends paid by the institutions, should be entitled to review of their claims for entire fairness under the Administrative Procedure Act – a solution that blends corporate law and administrative law. Our approach will discipline the government’s use of regulation by deal in future economic crises, and provide some ground rules for its exercise at the end of this one – without providing activist investors, whom we contend are becoming increasingly important players in regulation, with an unwarranted windfall.

Reading the briefs in the various GSE lawsuits, one feels lost in the details of the legal arguments and one thinks that the judges hearing these matters might feel the same way.  This article is an attempt to see the big picture, encompassing the administrative, corporate and takings law aspects of the dispute. However the judges decide these cases, one would assume that they will need to do something similar to come up with a result that they find just.

I also found plenty to argue with in this article.  For instance, it characterizes the Federal Housing Finance Administration as the lapdog of Treasury. (26) But there is a lot of evidence that the FHFA charted its own course away from the Executive Branch on many occasions, for instance when it rejected calls by various government officials for principal reductions for homeowners with Fannie and Freddie mortgages. Notwithstanding these disagreements, I think the article makes a real contribution in its attempt to make sense of an extraordinarily muddled situation.

Here: Complaint in Louise Rafter et al. v. U.S.

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Here is a copy of the Complaint in Louise Rafter et al. v. U.S., Pershing Square’s Takings case in the U.S. Court of Federal Claims. I will blog about it later, but thought that some might want to see it as soon as possible because it is not widely available yet.

Investors Unite for High GSE-Fees

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Investors Unite, a “coalition of private investors . . . committed to the preservation of shareholder rights for those invested in” Fannie Mae and Freddie Mac sent a letter to FHFA Director Watt pushing for higher guarantee fees (g-fees). The technical issue of how high g-fees should be set actually contains important policy implications, as I had blogged about earlier.

Tim Pagliara, the Executive Director of Investors Unite, writes,

g-fees were historically determined by the GSEs and FHFA does not have a mandate as conservator to run the GSEs as not-for-profit entities. We urge you to adhere to a set of principles that takes into account the critical purpose of setting appropriate guarantee fees while respecting the rights of all economic stakeholders, including the GSE’s shareholders. Ideally, after undoing the 2012 sweep, when setting guarantees fees, FHFA should also take into full consideration that:

1. Fannie Mae and Freddie Mac have profit-making purposes onto which public mandates are layered, and they should charge guarantee fees that earn an appropriate market-based return on the capital employed, whether taxpayer capital or private capital. This is an absolutely critical factor “other than expected losses, unexpected losses and G&A fees” that should be considered when determining g-fees.

2. Increasing guarantee fees will provide more cash flow with which the GSEs can build capital and be restored to “safe and solvent condition.” Maximizing returns is not only consistent with, but arguably required by, the conservatorship.

3. FHFA as conservator has legal duties to the direct economic stakeholders – including all shareholders – that must be respected alongside the interests of other parties.

4. Earning an appropriate return on capital is entirely consistent with the conservatorship and affordable housing mandates. There is no conflict here between the GSEs building capital and setting aside funds for affordable housing. Indeed, it is only when the GSEs have earned their way back to a “safe and solvent condition” that they can sustainably meet their public affordable-housing mandates. After the GSEs have adequate capital, the suspension of those mandates can be reversed, i.e. the affordable housing support can be turned back on.

5. Keeping guarantee fees low to support the housing market in general, including homeowners and homebuyers that are well off and do not need help, is not as important as charging higher guarantee fees (a) to build a capital base to protect against future credit losses, and (b) to redistribute a portion of earnings to targeted constituencies that  particularly need financial support.

6. Guarantee fee rates should be tied to sound underwriting standards. If FHFA directs the GSEs to relax underwriting standards, it is essential that guarantee fees be adjusted upwards to account for the greater credit risk assumed in doing so.

Ultimately, g-fees profits should be allowed to stay within the housing market and should be set at levels that help ensure safety and soundness of the GSEs, that protect long-term health of the housing market, and that respect the rights of all economic stakeholders-including the GSE’s shareholders. (1-2, emphasis added)

This letter goes to the heart of the g-fee debate and the GSE litigation, as far as I am concerned.  The g-fee level will determine whether Fannie and Freddie shares have any value at all. A low g-fee means no profits and no value. A high g-fee means profits and shareholder value. I agree with Pagliara that g-fees should reflect “sound underwriting.” The FHFA should therefore clearly outline the goals that the g-fee is intended to achieve. I may disagree with Pagliara as to what those goals should be, but sound underwriting is key to any vision of a sustainable housing finance market.

The Government Takeover of Fannie and Freddie

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Richard Epstein has posted a draft of The Government Takeover of Fannie Mae and Freddie Mac: Upending Capital Markets with Lax Business and Constitutional Standards. The paper addresses “the various claims of the private shareholders, both preferred and common, of Fannie and Freddie.” (2) He notes that those claims have

now given rise to seventeen separate lawsuits against the Government, most of which deal with the Government’s actions in August, 2012. One suit also calls into question the earlier Government actions to stabilize the home mortgage market between July and September 2008, challenging the constitutionality of the decision to cast Fannie and Freddie into conservatorship in September 2008, which committed the Government to operating the companies until they became stabilized. What these suits have in common is that they probe, in overlapping ways, the extent to which the United States shed any alleged obligations owed to the junior preferred and common shareholders of both Fannie and Freddie. At present, the United States has submitted a motion to dismiss in the Washington Federal case that gives some clear indication as to the tack that it will take in seeking to derail all of these lawsuits regardless of the particular legal theory on which they arise. Indeed, the brief goes so far to say that not a single one of the plaintiffs is entitled to recover anything in these cases, be it on their individual or derivative claims, in light of the extensive powers that HERA vests in FHFA in its capacity as conservator to the funds. (2-3, citations omitted)

Epstein acknowledges that his “work on this project has been supported by several hedge funds that have hired me as a legal consultant, analyst, and commentator on issues pertaining to litigation and legislation over Fannie and Freddie discussed in this article.”(1, author footnote) Nonetheless, as a leading scholar, particularly of Takings jurisprudence, his views must be taken very seriously.

Epstein states that “major question of both corporate and constitutional law is whether the actions taken unilaterally by these key government officials could be attacked on the grounds that they confiscated the wealth of the Fannie and Freddie shareholders and thus required compensation from the Government under the Takings Clause. In addition, there are various complaints both at common law and under the Administrative Procedure Act.” (4)

Like Jonathan Macey, Epstein forcefully argues that the federal government has greatly overreached in its treatment of Fannie and Freddie. I tend in the other direction. But I do agree with Epstein that it “is little exaggeration to say that the entire range of private, administrative, and constitutional principles will be called into question in this litigation.” (4) Because of that, I am far from certain how the courts should and will decide the immensely complicated claims at issue in these cases.

In any event, Epstein’s article should be read as a road map to the narrative that the plaintiffs will attempt to convey to the judges hearing these cases as they slowly wend their way through the federal court system.

Stealing Fannie and Freddie?

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Jonathan Macey and Logan Beirne have posted a short working paper, Stealing Fannie and Freddie, to SSRN. It advocates a position similar to that taken by the plaintiffs in the GSE shareholder litigation. They argue,

Politicians are running rough-shod over the rule of law as they seek to rob private citizens of their assets to achieve their own amorphous political objectives. If we were speaking of some banana republic, this would be par for the course – but this is unfolding in the United States today.

“The housing market accounts for nearly 20 percent of the American economy, so it is critical that we have a strong and stable housing finance system that is built to last,” declares the Senate Banking Committee Leaders’ Bipartisan Housing Finance Reform Draft. The proposed legislation’s first step towards this laudable goal, however, is to liquidate the government sponsored enterprises Fannie Mae and Freddie Mac – in defiance of the rule of law. This paper analyzes the current House and Senate housing finance reform proposals and faults their modes of liquidation for departing from legal norms, thereby harming investors and creditors, taxpayers, and the broader economy.

Under proposals before Congress, virtually everyone loses. First, the GSEs’ shareholders’ property rights are violated. Second, taxpayers face the potential burden of the GSEs’ trillions in liabilities without dispensing via the orderly and known processes of a traditional bankruptcy proceeding or keeping the debts segregated as the now-profitable GSEs seek to pay them down. Finally, the rule of law is subverted, thereby making lending and business in general a riskier proposition when the country and global economy are left to the political whims of the federal government. (1)

I found a number of unsupported assertions throughout the piece. For instance, they assert, without support, that Fannie and Freddie “never reached the point of insolvency.” (3)  Badawi & Casey convincingly argue that without “government intervention, [Fannie and Freddie] would have defaulted on their guaranty obligations and more generally on obligations to all creditors.” (Badawi & Casey at 5) All in all, I don’t find this short working paper to be compelling reading — perhaps a more comprehensive one is in the works.

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.

Stressing out on Fannie and Freddie

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The Federal Housing Finance Agency issued Projections of the Enterprises’ Financial Performance (Stress Tests) (Apr. 30, 2014). This is a pretty technical, but important, document. The Background section provides some needed context:

This report provides updated information on possible ranges of future financial results of Fannie Mae and Freddie Mac (the “Enterprises”) under specified scenarios, using consistent economic conditions for both Enterprises.

*     *     *

. . . the Dodd-Frank Act requires certain financial companies with total consolidated assets of more than $10 billion, and which are regulated by a primary Federal financial regulatory agency, to conduct annual stress tests to determine whether the companies have the capital necessary to absorb losses as a result of adverse economic conditions. This year is the initial implementation of the Dodd-Frank Act Stress Tests.

In addition to stress tests required per the Dodd-Frank Act, this year as in previous years, FHFA worked with the Enterprises to develop forward-looking financial projections across three possible house price paths (the “FHFA scenarios”). The Enterprises were required to conduct the FHFA scenarios as they have in the past, in conjunction with the initial implementation of the Dodd-Frank Act Stress Tests.

*     *     *

The projections reported here are not expected outcomes. They are modeled projections in response to “what if” exercises based on assumptions about Enterprise operations, loan performance, macroeconomic and financial market conditions, and house prices. The projections do not define the full range of possible outcomes. Actual outcomes may be very different. (4, emphasis in the original)

 The stress test results are as follows:

Dodd-Frank Act Stress Tests Severely Adverse Scenario

  • As of September 30, 2013, the Enterprises have drawn $187.5 billion from the U.S. Treasury under the terms of the Senior Preferred Stock Purchase Agreements (the “PSPAs”).
  • The combined remaining funding commitment under the PSPAs as of September 30, 2013 was $258.1 billion.
  • In the Severely Adverse scenario, incremental Treasury Draws range between $84.4 billion and $190.0 billion depending on the treatment of deferred tax assets.
  • The remaining funding commitment under the PSPAs ranges between $173.7 billion and $68.0 billion. (3)

FHFA Scenarios

  • In the FHFA scenarios, cumulative, combined Treasury draws at the end of 2015 remain unchanged at $187.5 billion as neither Enterprise requires additional Treasury draws in any of the three scenarios.
  • The combined remaining commitment under the PSPAs is unchanged at $258.1 billion.
  • In the three scenarios the Enterprises pay additional senior preferred dividends to the US Treasury ranging between $54.0 billion to $36.3 billion. (3)

There are a number of important points to keep in mind when reviewing this report. First, it addresses just four scenarios out of the the multitude of possible ones. But hopefully the Severely Adverse Scenario gives us a sense of the outer limits of what a crisis could do to the Enterprises and the taxpayers who backstop them.

Second, the report is another corrective to arguments that the federal government’s bailout of the Enterprises can be measured by the amount of money that they actually advanced to the two companies, as opposed to a measure that also accounts for the additional amount that the federal government is committed to provide them if their financial situation takes a turn for the worse.

Finally, as I have noted before, there is an important political battle for control of the narrative of the bailout of the Enterprises. The only narrative during the crisis itself was that the federal government bailed out the two companies because they were insolvent. Revisionist histories, put forward in the main by private shareholders of the two Enterprises, challenge that narrative. The shareholders put forth another version of history: the federal government effectively stole  solvent, viable Fannie and Freddie from them. It will be important for objective third parties to document the truth about this in accordance with Generally Accepted Accounting Principles. From my understanding of the facts, however, it is clear that the two companies were as good as dead when the federal government put them into conservatorship in 2008 and started advancing them tens of billions of dollars year after year until their fortunes turned around in 2012.