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By Mark A. Calabria and Michael A. Krimminger
Mark A. Calabria is director of financial regulation studies at the Cato Institute. Before joining Cato in 2009, he spent six years as a member of the senior professional staff of the U.S. Senate Committee on Banking, Housing and Urban Affairs.
Michael A. Krimminger has been a partner at Cleary Gottlieb Steen & Hamilton LLP since 2012. Previously, he served for more than two decades in numerous leadership positions with the Federal Deposit Insurance Corporation (FDIC), including most recently as its general counsel.
Recent reports about federal court decisions in lawsuits challenging actions by Treasury and the Federal Housing Finance Agency (FHFA) in the conservatorships of Fannie Mae and Freddie Mac may lead some to conclude that the government has been vindicated. However, a look beneath the surface reveals that these initial decisions do not address the substance of the challenges to the actions in the conservatorships of these two government-sponsored enterprises, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association (GSEs)– particularly the 2012 Treasury-imposed changes to the original conservatorship agreement.
The Treasury changes, embodied in the “Third Amendment,” implemented a “net worth sweep” that strips the GSEs of their entire net worth each quarter and prevents the accumulation of any funds to repay pre-conservatorship shareholders, or build capital or any buffer against future losses. In addition, it explicitly reduces to zero the GSEs' minimal reserve against losses by 2018. Fundamentally, this action ignored the statute governing the conservatorships, the Housing and Economic Recovery Act (HERA), and decades of established practice.
While there remain multiple lawsuits challenging Treasury's and the FHFA's action, this is not a dispute that only affects the GSEs' stakeholders. First, the Third Amendment leaves the taxpayers on the hook once again because it deprives Fannie and Freddie of 100 percent of their net worth and leaves no buffer against future losses. Second, as described below, it manipulates the conservatorship process to redirect billions of dollars to the government's general operating budget, with no accountability over how funds are spent.
Finally, these unprecedented deviations from settled insolvency practices and creditor protections undercut one of the critical foundations of a market economy. Fair and predictably- applied insolvency rules allow investors, creditors and even consumers to judge the risks of investing in, doing business with, or buying products or services from a company. If that process can be manipulated to favor one creditor—as FHFA has favored Treasury—then there is no basis to judge what could happen to investors or any other creditor if a company fails. This is particularly troubling because it is the government that has subverted the normal conservatorship process. It could call into question the reliability of any process where the government controls the rehabilitation or resolution of a company.
Having been closely involved in the drafting of the HERA, in our respective capacities as the senior professional staff member of the U.S. Senate Committee on Banking, Housing and Urban Affairs and as a senior policy adviser to the Chairman of the Federal Deposit Insurance Company, we bring to this debate both legislative and practical experience in the meaning and application of these laws and policies.
Fundamentally, HERA was designed to follow the FDIC's tried and true resolution process for failing banks—in fact, HERA is virtually identical to the conservatorship and receivership provisions of the Federal Deposit Insurance Act (FDIA). However, the bottom line is that the government's actions in the GSE conservatorships violate the statutory language as well as the intent of HERA, and ignore the FDIC's long-standing practices under the FDIA.
The 2008 crisis exposed serious weaknesses in the financial condition of the GSEs. Given the systemic risk posed by the collapse of such large institutions, Congress enacted and President George W. Bush signed into the law the Housing and Economic Recovery Act of 2008 (HERA).
In drafting HERA, Sen. Richard Shelby, ranking member of the Senate Banking Committee, directed his staff to make those provisions as “bank-like” as possible. Staff quite literally “marked-up” Sections 11 and 13 of the FDIA as the base text for HERA. The Banking Committee consciously wished to apply the existing body of FDIC legal precedent to any conservatorship or receivership for the GSEs. In doing so the Committee believed that building upon the established framework of the FDIC would provide both courts and market participants with greater predictability.
The FDIC has a long record of resolving failing banks and thrifts. While receiverships have been the norm under the FDIA in the past twenty-five years, prior to the 1990s, the FDIC had frequently made use of open bank assistance and conservatorships as a preferred method to resolve failing insured banks and thrifts. The goal of this process was to rehabilitate the troubled bank and return it to normal banking operations in full compliance with requisite regulatory standards, including adequate capitalization. If that was not possible, the bank was put into receivership. In open bank assistance and conservatorship resolutions, the FDIC received repayment of the assistance that was provided, with interest, if possible but it never had a right to sweep all future net worth.
Like the FDIA, the resolution framework that Congress intended when it enacted HERA in 2008 very clearly requires FHFA, when acting as conservator, to “preserve and conserve” the assets of the GSEs and rehabilitate them to a “sound and solvent” condition in compliance with all regulatory capital and other prudential standards to permit their safe return to private control. If that is not possible because the GSEs become insolvent or unable to pay their debts as they come due, FHFA is required under HERA to place them into receivership, and pay stakeholders from the proceeds. In either case, as under the FDIA, the government is entitled to receive only its administrative expenses, and certainly not all of the Company's value beyond what it had invested. While it may be understandable that Treasury decided to take a different approach due to the absence of a final, political decision on the future of the GSEs, the actions Treasury and FHFA have taken do not comply with HERA.
Nothing in this statutory framework allows permanent conservatorships that strip the GSEs down to zero net worth while they are generating billions of dollars in profits. This is all the more unsupportable under HERA when the Treasury has been repaid billions of dollars more than its funding to the GSEs. These actions violate HERA and the long-standing precedents on which it is based because they avoid the stakeholder protections built into open bank assistance, conservatorships and receiverships.
At the time HERA was enacted, then-FHFA Director James Lockhart stated that the critical mission of the GSEs of providing stability and liquidity to the housing market required a very careful and delicate balance of mission and safety and soundness. When the GSEs were placed into conservatorship in September 2008, he acknowledged that a key component of this balance, their ability to raise and maintain capital, had been lost in the midst of the financial crisis. As a result, he asserted that it was necessary to place them into FHFA conservatorships in “a statutory process designed to stabilize troubled institutions with the objective of returning the entities to normal business operations.” He confirmed that “[t]he goal of these actions is to help restore confidence in Fannie Mae and Freddie Mac, enhance their capacity to fulfill their mission, and mitigate the systemic risk that has contributed directly to the instability in the current market.”
To provide temporary funding, Treasury simultaneously announced that was providing up to $100 billion in liquidity for each of the GSEs, pursuant to temporary authority granted it under HERA, in exchange for senior preferred stock under Senior Preferred Stock Purchase Agreements or PSPAs. The senior preferred stock had an initial liquidation preference of $1 billion and Treasury was entitled to a quarterly dividend equal to 10 percent of its outstanding liquidation preference.
Treasury also received a warrant to purchase 79.9 percent of the common stock for a nominal price, and a Periodic Commitment Fee (PCF) which was to be set by mutual agreement with FHFA at the market price. To have crossed the 80-percent threshold would have constituted government ownership of the GSEs, an option policymakers rejected.
Therefore, while the terms of the PSPAs could dilute the value of the existing shareholders' interests in the GSEs, those shares continued to exist and nationalization of the institutions was consciously avoided. As then-Treasury Secretary Paulson explained, “…conservatorship does not eliminate the outstanding preferred stock.” FHFA also confirmed that the “[s]tockholders will continue to retain all rights in the stock's financial worth; as such worth is determined by the market.”
The Third Amendment Net Worth Sweep
In August 2012, as the GSEs began to turn a corner toward recovering value for equity holders, Treasury and FHFA announced that they had agreed to a modification to the PSPAs – the so-called “Third Amendment” or “Net Worth Sweep” – in which the quarterly dividend to Treasury of 10% of its liquidation preference was replaced by a quarterly dividend to Treasury equal to the GSEs' entire net worth while eliminating the minimal remaining reserve by 2018. Significantly, the Third Amendment characterizes the net worth sweep as a dividend. As a result, the government now claims that the net worth sweep payments do not reduce Treasury's liquidation preference, which is thus effectively fixed at about $189.5 billion in both GSEs combined. This is despite the fact that Fannie and Freddie have paid back $40 billion more than they were ever loaned in the first place.
HERA has an explicit control to prevent this endless conservatorship. HERA requires FHFA to place the Companies into receivership if the FHFA Director finds them to be insolvent or unable to pay their debts as they come due. To discipline this process, the FHFA Director is required to “make a determination, in writing,” as to whether the Companies meet the requirements for mandatory receivership every thirty days after they become “critically undercapitalized.” As a result, if the GSEs cannot pay their debts as they come due without Treasury assistance, then they are insolvent under the HERA statutory test. So long as Treasury sweeps the value of the GSEs to finance general government functions, the restoration of the GSEs to a sound and solvent condition will remain impossible and taxpayers will remain on the hook for losses that are almost certain to occur in the typical swings of a market economy.
In response, Treasury has argued that its commitment to the GSEs is essential for their continued operation, while also arguing that its commitment essentially makes them solvent, so they require no capital. This is the epitome of the circular argument. Not only does this run contrary to the letter and spirit of HERA, it contravenes logic.
The Role of the Treasury
Congress consciously chose to vest FHFA with the sole authority on whether to proceed with a conservatorship or receivership. The roles of other agencies, notably Treasury, were purposely made narrow and limited. The Banking Committee's intent in HERA was to limit the role of Treasury to one of creditor, even if a preferred creditor. Both the House and Senate Committees with jurisdiction on the legislation debated a larger policy role for Treasury but ultimately rejected it. The drafters of HERA never envisioned, nor intended, for Treasury to maintain a large equity stake in the companies.
Some interpret HERA and comments at the time from Treasury Secretary Paulson to mean that HERA allows the government to take over the assets of Fannie Mae and Freddie Mac with all powers of the shareholders so long as the conservatorship remains in effect.
But, as noted, this ignores the fact that HERA requires FHFA, as conservator, to do whatever is needed to “conserve and preserve” the GSE's assets and the explicit and separate direction to the FHFA, as conservator, to take steps necessary to put the regulated entity in a “sound and solvent condition.” If that is not possible, then HERA requires the FHFA to place the GSEs into receivership. The law does not allow an endless conservatorship as a means to strip value, trample stakeholders' rights, and transform the GSEs into governmental housing agencies.
Some would argue that Treasury is acting within its authority given that it infused billions of dollars into the GSEs in order to keep them solvent. No one disputes that Treasury acted decisively and in the interests of shareholders and the public at large in preventing the collapse of Fannie and Freddie. However, Treasury's actions in the Third Amendment completely changed the relationship between Treasury and the GSEs from one in which Treasury provided statutory assistance that the GSEs would repay, which would be consistent with FDIC precedents, to one in which Treasury seizes all current and future net worth.
This latter approach is confiscatory and has no relationship to repayment of the assistance provided and completely disregards all past precedents from FDIC open bank assistance and conservatorships. While Treasury is entitled to be, and has been, repaid for the assistance provided, nothing in HERA or its antecedents supports the Third Amendment. Treasury has no authority to use Fannie and Freddie as a never-ending revenue stream.
In 2013, several holders of preferred and common stock in the GSEs filed suit challenging the Third Amendment under various legal theories, including that the sweep violated HERA and so must be enjoined under the Administrative Procedure Act, and that the sweep constituted an unconstitutional taking such that the government should be ordered to provide just compensation.
On Sept. 30, 2014, Judge Royce Lamberth of the U.S. District Court for the District of Columbia dismissed several such suits, finding that the court did not have jurisdiction to enjoin the conservator because the net worth sweep was within the conservator's broad powers (In re Fannie Mae/Freddie Mac Senior Preferred Stock Purchase Agreement Class Action Litigations, D.D.C., No. 13-1288). The plaintiffs' appeal of that decision is pending and it is likely the appeals process in this and other cases will continue for months if not years.
The January 2015 decision by Judge Robert Pratt to dismiss the Iowa case last month on procedural grounds was rooted in the fact that the plaintiffs were essentially the same as in Lamberth's case (Continental Western Insurance Co. v. The Federal Housing Finance Agency, et al., S.D. Iowa, No. 4:14-cv-00042).
Besides these two cases, a suit by Fairholme in the U.S. Court of Federal Claims is also ongoing, and the government has lost several motions recently to squelch discovery (Fairholme Funds Inc v. United States, Ct. Fed. Cl., No. 13-465 C).
Treasury's and the FHFA's actions in the GSE conservatorships continue to ignore the governing law. This is not a dispute that only affects the Companies' stakeholders, because it leaves taxpayers exposed to new risks from the GSEs without any buffer and manipulates the insolvency process in a way that erodes market confidence. Furthermore, these unprecedented deviations from settled insolvency practices and creditor protections undercut one of the critical foundations of a market economy. Fair and predictably-applied insolvency rules allow investors, creditors and even consumers to judge the risks of investing in, doing business with, or buying products or services from a company. We must ensure a return to these principles for two of our largest financial companies.
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