Ruling in Perry Capital Appeal Shackles Fannie Mae/Freddie Mac Shareholders

One buys stock with an understanding that the rules affecting profit and loss won’t change without warning. The U.S. Court for Appeals, District of Columbia Circuit, apparently believes otherwise. On February 21, the court ruled 2-1 that investors in shares of secondary residential mortgage lenders Fannie Mae and Freddie Mac, as managed by Perry Capital LLC, a New York hedge fund, have no right to realize their accrued profits. The decision continues the federal conservatorship of the two companies established in 2008. The case was triggered by the “sweep rule” issued by the Treasury Department in August 2012. That rule confiscated dividends as repayment for $187.5 billion in emergency loans even though the corporations have repaid far more than that. The case, one of many such suits, is a lesson on the perils of government bailouts.

National Legal and Policy Center on many occasions has analyzed the Fannie Mae and Freddie Mac financial crisis and the various proposed remedies for it. The problem has its roots in the implicit, and misguided, idea that homeownership is a right and that housing policy must promote that right at whatever risk to the public. For decades, these publicly-traded companies, for better or worse, have played a central role in providing residential mortgage credit. The Washington, D.C.-based Federal National Mortgage Association (“Fannie Mae”) and the McLean, Va.-based Federal Home Loan Mortgage Corporation (“Freddie Mac”) were chartered by Congress, respectively, in 1968 and 1970 as secondary mortgage enterprises (Fannie Mae actually began as a government agency back in 1938). Rather than make mortgage loans, these firms buy loans from primary lenders, such as banks and savings & loan associations, and then hold them for investment or package them as bonds, or “mortgage-backed securities,” to investors. Securitization long has been the main focus. As of this March, Fannie Mae and Freddie Mac held or guaranteed a combined $4.85 trillion in residential mortgages, a sum representing over 40 percent of the nation’s $11.45 trillion worth of outstanding mortgage debt. The idea behind securitization is to enable lenders to convert mortgage assets to cash. This arrangement effectively connects Main Street with Wall Street, to the benefit of everyone. Banks can unload long-term assets and thus gain flexibility for lending for other purposes. Individual and institutional bondholders receive a steady income stream. And home mortgage borrowers see a lowering of their interest rates typically between 20 and 50 basis points; i.e., 0.20 to 0.50 of one percentage point.

Winning in theory, however, doesn’t necessarily translate into winning in practice, at least not over the long run. Fannie Mae and Freddie Mac long have functioned as a government-driven duopoly, enjoying advantages unavailable to market competitors. This includes automatic access to a U.S. Treasury line of credit, originally set at $2.25 billion for each and eventually raised to $200 billion for each during the mortgage crisis of 2008-09, and exemption from state/local taxes. For years, the government had an implicit mandate to stand by these companies, as they were “too big to fail,” as expression would have it.

But the arrangement had a great disadvantage: The companies were tethered to increasingly stringent mandates to lower standards of risk evaluation. As such, primary lenders, knowing that the government would provide a backstop, had an incentive to underwrite loans to people who should not have received one at all or who bought a home well outside their price range. Spurred by the housing reauthorization law of 1992, and accelerating thereafter, Fannie Mae/Freddie Mac’s regulator, the U.S. Department of Housing and Urban Development (HUD), imposed aggressive standards to promote homeownership for low- and moderate-income households, especially those who were black or Hispanic. This contributed heavily to an unprecedented mortgage boom lasting well into the next decade. By around 2007-08 Fannie Mae and Freddie Mac were buying around 70 percent of all newly-originated home mortgages for purchase. That’s when the bubble burst. Mortgage defaults and foreclosures noticeably rose. Prices fell, especially in areas with high concentrations of unqualified or underqualified recent borrowers. Fannie Mae and Freddie Mac bondholders suddenly found themselves dangerously exposed, as the companies were in danger of failing to meet their mandated minimum capital requirements.  The nation’s credit system was in peril.

By the summer of 2008, financial intermediaries with heavy mortgages bond exposure were facing ruin. At least one of them, Bear Stearns, already had gone under months earlier. That July, Federal Deposit Insurance Corporation seized the collapsed Pasadena, Calif.-based mega-thrift IndyMac, putting its assets up for sale. Even more calamitous, the Merrill Lynch and Lehman Brothers investment houses were on the verge of an inevitable meltdown. Recognizing a crisis, Congress passed and President Bush signed the Housing and Economic Recovery Act (HERA) in July. The law replaced Fannie Mae/Freddie Mac regulator as well; in the place of HUD would be a new agency, the Federal Housing Finance Agency (FHFA). The law vested FHFA with extraordinary emergency powers including the authority to seize Fannie Mae and Freddie Mac. Several weeks later, during September 6-7, FHFA used this power. At the urging of Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson, FHFA Director James Lockhart placed Fannie Mae and Freddie Mac under emergency conservatorship. Under the arrangement, the companies could continue operating, but under severe constraints so as to fulfill all bondholder claims. But fulfillment would require money. And as these two companies were dangerously close to running out of cash, the Treasury Department stepped in to provide it. In a succession of transactions over the next several years, the department loaned the companies a total of $187.5 billion, around $116.5 billion of which went to Fannie Mae and $71 billion went to Freddie Mac. In return, the government received senior preferred stock with a quarterly dividend set at 10 percent of all borrowed funds. Additionally, the U.S. Treasury now had the option to buy 79.9 percent of outstanding common stock. The companies had no right to buy back any of these forfeited shares. These were pretty tight strings. Yet however reluctantly, Fannie Mae and Freddie Mac took the medicine. A conservatorship was still preferable to outright receivership. The companies had little market value left. Indeed, in June 2010, each company, by now a penny stock, was de-listed from the New York Stock Exchange.

Things looked grim. Defaults and foreclosures were piling up nationwide. And then came a deus ex machina:  a housing market rebound during 2011-12. Real estate is back, declared Fortune magazine. Demand, as it turned out, had not died, but merely hibernating. Housing construction, sales, improvement and refinancing were on the upswing. Prices, as measured by the Standard & Poor’s/Case Shiller Housing Index of single-family detached dwellings in 20 selected metro areas, were registering annualized monthly increases of 10 percent or more. The Federal Reserve System drove much of this comeback via its latest round of an economic stimulus program known as “quantitative easing,” which at the time involved the Fed buying $85 billion in bonds per month – $45 billion in Treasury bonds and $40 billion in Fannie Mae/Freddie Mac mortgage-backed securities. In 2012, Fannie Mae and Freddie Mac once again became profitable.

The U.S. Treasury Department and the Federal Housing Finance Agency had taken note. To these agencies, a profitable Fannie Mae and Freddie Mac presented an opportunity to speed up the repayment of what they owed. Despite making timely payments, they were holding a weak hand. On August 17, 2012, the Treasury Department, with full support from FHFA, sprung a surprise: Amendment Three, also known as the “net worth sweep” or “sweep amendment.” The regulation, set to go into effect the following year, superseded the 10 percent dividend requirement. Treasury now had the authority to lock up quarterly profits for as long as it deemed necessary. Shareholders had no access to these profits. By any reasonable definition, the action constituted an unconstituional taking.

The rule “worked” insofar as the government defined the criteria. In 2013, Fannie Mae and Freddie Mac sent a combined $130 billion to the Treasury, a sum nearly seven times what would have been the case in the absence of the sweep rule. The losers were shareholders who had bought stock, whether as individuals or through institutions such as mutual funds and hedge funds. The government, in its haste to accelerate debt collection, overlooked due process. Its prevailing attitude seemed to be that if shareholders didn’t like the sweep rule, they could sue to get their money back.

Which is exactly what many of them did.  Investors with large stakes in Fannie Mae and Freddie Mac filed a combined roughly 20 lawsuits in federal court to declare the sweep rule invalid and/or demand transparency as to how the rule came about.  Perry Capital was one of those entities. Its suit, filed in July 2013 as Perry Capital v. Lew et al., listed Treasury Secretary Jack Lew and FHFA Director Mel Watt, and their respective agencies, as defendants. The shareholders had a solid case. Their stock had been brutally depressed by the mortgage industry meltdown and the conservatorship. That said, there was an estimated $33 billion at stake. Representing Perry Capital was former Justice Department Solicitor General (during the first term of President George W. Bush) and current Gibson Dunn & Crutcher partner Ted Olson. “It is the official position of the government to deprive shareholders of all gains,” Olson remarked at a February 5, 2014 forum in Washington, D.C. organized by aggrieved shareholders. The sweep rule, he said, amounted to legalized theft. The Treasury Department, as the majority shareholder, had reneged on its fiduciary duties. Weeks earlier, the department unwittingly had validated the charge, stating in a January 17, 2014 court filing that Fannie Mae/Freddie Mac shareholders “do not possess an unfettered right to a dividend.”

The government’s main lines of defense – that the sweep rule was fiscally necessary and that the Housing and Economic Recovery Act of 2008 explicitly authorized it – seemed convincing. Yet there was strong evidence that the Treasury rule was motivated by a desire to maximize government revenues at the expense of investor rights. In oral arguments last April, plaintiffs’ lawyers presented deposition testimony from July 2015 by former Fannie Mae chief financial officer Susan McFarland unsealed only two days earlier by Judge Margaret Sweeney of the U.S. Court of Federal Claims. Back in August 2012, McFarland had told senior officials at the Treasury Department and the Federal Housing Finance Agency that Fannie Mae and Freddie Mac had become profitable and expected to remain that way for some time. “It was precisely that moment, literally days later,” Perry Capital attorney Matthew McGill noted afterward, “that the government made the decision to take all of the profits for themselves forever.” He elaborated:

In the lower court, the government told a story…that in 2012 Fannie Mae and Freddie Mac were at death’s door, and the only way to keep them alive would be to do the trade, where the government would trade a 10 percent dividend for the net worth sweep. But what these seven documents show is that that narrative was false from the beginning. The immediate goal is for an order that vacates the Third Amendment and requires FHFA and Treasury to follow the law and act as a conservator.

This wasn’t the only indication that Treasury officials valued power over principle. On July 30, 2014, an unnamed source leaked a confidential 52-page document via the Web, dated June 13, 2011, indicating that the department had been shopping Fannie Mae and Freddie Mac around to corporate suitors. The document bore the imprint of the New York-based equity fund, The Blackstone Group, and Blackstone’s law firm, Skadden Arps. National Legal and Policy Center obtained a copy of the report, and discussed its content and implications in August 2014. I wrote back then:

A large Blackstone equity stake in the GSEs (i.e., Fannie Mae and Freddie Mac) might well improve the bottom line of each company, but achieving this outcome must proceed from rule of law. That is, it can’t bypass the legitimate interests of Fannie Mae/Freddie Mac investors whose equity is now indefinitely locked up. While the conservatorship instituted six years ago was never meant to be permanent, any alternative arrangement must respect shareholder rights. As for an alternative, here’s one: Rescind the sweep rule, and let Fannie Mae and Freddie operate on their own without any too-big-to-fail government guarantee.

In Perry Capital, as in several other shareholder complaints, this argument did not succeed in the lower court. On September 30, 2014, Judge Royce Lamberth, representing the U.S. District Court for the District of Columbia, dismissed all of the plaintiffs’ claims. The Treasury Department, concluded Lamberth, was authorized to “purchase any obligations and other securities issued by” Fannie Mae and Freddie Mac, a provision also authorizing the department to “exercise any rights received in connection with such purchases.” The Third Amendment, he said, may “raise eyebrows, or even engender a feeling of discomfort, but any sense of unease over the defendants’ conduct is not enough to overcome the plain meaning” of the text of the HERA legislation. Judge Lamberth continued: “Here, the plaintiffs’ true gripe is with the language of a statute that enabled FHFA and, consequently, Treasury, to take unprecedented steps to salvage the largest players in the mortgage finance industry before their looming collapse triggered a systemic panic.” In effect, the court’s position was that receiving a government loan obligates the recipient to repay in perpetuity.

The consequences of the district court ruling would be felt immediately. On the next day, October 1, 2014, preferred share prices for Fannie Mae and Freddie Mac plummeted by more than 50 percent, while common share prices declined by almost 40 percent. Perry Capital, recognizing its clients faced a wipeout, wasted no time in filing an appeal requesting that the Treasury Department return excess payments extracted by the sweep rule. The plaintiffs argued that the Federal Housing Finance Agency had reneged on its fiduciary duty to the public to conserve assets and return the firms to the marketplace. Ironically, Fannie Mae and Freddie Mac had become solvent again anyway. In 2013, the year the sweep rule went into effect, the corporations posted respective net incomes of $84.0 billion and $48.7 billion. Moreover, through Fourth Quarter 2016, these enterprises not only had repaid the Treasury Department the entire $187.5 billion borrowed, but nearly $75 billion on top of that; dividends scheduled for forwarding to the Treasury Department for Fourth Quarter 2016 alone totaled $10 billion. But as the department viewed dividends as debt rather than as profit, investors continued to be left out in the cold.

The government argued that the companies owed their newfound solvency to the sweep rule. The plaintiffs, asserted the government’s lawyers, were putting the cart before the horse. Yet as discussed earlier, the crisis may have been manufactured, so as to justify a more stringent confiscation of profit, and then covered up. In her ruling this past April 13, U.S. Court of Claims Judge Margaret Sweeney unsealed seven documents from assorted shareholder cases, including the Perry Capital case. These documents – excerpts of three depositions and four e-mails – cast a shadow of doubt upon the claim that the rule was necessary to avert a “death spiral,” in the words of FHFA. Former Fannie Mae CFO Susan McFarland’s previously cited deposition was damning enough. There also was the deposition of Mario Ugoletti, former special advisor to the director of the FHFA. Ugoletti admitted that he had no idea what Treasury or FHFA thought about the release of Fannie Mae/Freddie Mac tax-deferred assets at the time of the Third Amendment’s issuance, even though he had stated earlier that certain officials of each agency believed that the material would not be released.

Other observers expressed skepticism over the legality of commandeering Fannie Mae/Freddie Mac profits. NYU/University of Chicago legal scholar Richard Epstein, writing in June 2015 in Forbes Online, argued that the Treasury Department has a constitutional obligation to return all excess payments generated by the sweep rule because the department had no right to receive those payments. And Fannie Mae/Freddie Mac shareholder Glen Bradford, writing last October 11 in an article for the Seeking Alpha financial blog site, asked: “Is this the first class of shares in history that doesn’t have standing to sue when their economic rights are taken away?  I don’t think so, but that’s based on my interpretation of reading all the legal briefs, the applicable law, and some case law.”

The transparency forced upon a highly secretive Treasury Department and FHFA did not swing the tide in favor of the plaintiffs. This February 21, about 10 months after the hearing arguments, the District of Columbia federal appeals court, by a 2-1 margin, upheld the lower court dismissal. Perry Capital shareholders, concluded Judges Patricia Millett and Douglas Ginsburg, were not entitled to relief:

We hold that the stockholders’ statutory claims are barred by the Recovery Act’s strict limitation on judicial review…We also reject most of the stockholders’ common-law claims. Insofar as we have subject matter jurisdiction over the stockholders’ common-law claims against Treasury, and Congress has waived the agency’s immunity from suit, those claims, too, are barred by the Recovery Act’s limitation on judicial review…As for the claims against FHFA and the Companies, some are barred because FHFA succeeded to all rights, powers, and privileges of the stockholders under the recovery Act…others fail to state a claim upon which relief can be granted. The remaining claims, which are contract-based claims regarding liquidation preferences and dividend rights, are remanded to the district court for further proceedings.

There wasn’t any way around it: The government won and the shareholders lost.

Lawyers for the government had built the core of their case around the wording of the legislation enabling the conservatorship. The 2008 HERA Act [12 U.S. Code 4511(b)(1),(2)] they argued, charges the director of the Federal Housing Finance Agency with overseeing prudential operations of Fannie Mae and Freddie Mac and ensuring that they operate in a safe and sound manner. More specifically, the legislation explicitly grants FHFA, as conservator, with broad authority over Fannie Mae/Freddie Mac operations [12 U.S. Code 4617 (a)(2)], including “reorganizing, rehabilitating, or winding up their affairs.” This section of the law, authorized FHFA to “take over the assets of and operate the regulated entity” and “may preserve and conserve the assets and property of the regulated entity.” Finally, the Recovery Act severely limited the power of judicial review of the conservatorship. The law stipulated that “no court may take any action to restrain or affect the exercise of powers or functions of the Agency as a conservator.”

The circuit court majority endorsed this position. The sweep rule, argued Millett and Ginsburg, was a justifiable effort to manage assets in accordance with taxpayer interests. Moreover, it was within the scope of the HERA law, which bars judicial review. “Accordingly, time and again,” the majority wrote, “the Act outlines what FHFA as conservator ‘may’ do and what actions it ‘may’ take.” They continued:

Entirely absent from the Recovery Act’s text is any mandate, command or directive to build up capital for the financial benefit of the Companies’ stockholders. That is noteworthy because, when Congress wanted to compel FHFA to take specific measures as conservator or receiver, it switched to language of command, employing “shall” rather than “may”…In short, the most natural reading of the Recovery Act is that it permits FHFA, but does not compel it in any judicially enforceable sense, to preserve and conserve Fannie’s and Freddie’s assets and to return the Companies to private operation. And, more to the point, the Act imposes no precise order in which FHFA must exercise its multifaceted conservatorship powers.

Thus, the majority affirmed the lower court dismissal, though allowing for lawsuits alleging breaches of contract and implied covenant remanded to the district court.

All this minimizes the context of events leading to conservatorship, something Judge Janice Rogers Brown addressed at length in her dissent. She noted, properly, that the increased exposure of Fannie Mae and Freddie Mac to a full-scale meltdown was not an accident but rather the result of “affordable housing” mandates forced upon the companies by Congress, and the Clinton and Bush administrations. The consensus in both major parties, and the real estate and banking industries, was that America’s homeownership rate was too low and that existing homeowners should be more able to take out home equity loans/lines of credit. Primary mortgage lenders, plus Fannie Mae and Freddie Mac, the argument went, needed to reach “underserved” populations, especially blacks and Hispanics. And if that meant lowering traditional risk assessment standards, then that was what had to be done. In time, there was a rapid growth of borrowers who clearly were not ready for homeownership, or if they were, had borrowed too heavily. During 2007, defaults and foreclosures were noticeably rising. The credit bubble was beginning to appear unsustainable. The next year the bubble burst with a vengeance. That’s what triggered the HERA law and, weeks later, the conservatorship. Judge Brown noted the irony of the federal government ignoring a crisis it had helped to create and then forcing unsuspecting Fannie Mae/Freddie Mac shareholders to bear the cost. Fittingly, share prices for each company fell by more than 30 percent during the hours following the appeals court decision.

Judge Brown’s dissent also challenged FHFA’s use of its authority. “(T)he question before the Court,” she wrote, “is not whether the good guys have stumbled upon a solution. There are no good guys. The question is whether the government has violated the legal limits imposed on its own authority.”  She elaborated:

Regardless of whether Congress had many options or very few, it chose a well-understood and clearly-defined statutory framework – one that drew upon the common law to clearly delineate the outer boundaries of the Agency’s conservator or, alternatively, receiver powers. FHFA pole-vaulted over those boundaries, disregarding the plain text of its authorizing statute and engaging in ultra vires conduct. Even now, FHFA continues to insist its authority is entirely without limit and argues for a complete ouster of federal courts’ power to grant injunctive relief to redress any action it takes while purporting to serve in the conservator role…While I agree with much of the Court’s reasoning, I cannot conclude the anti-injunction provision protects FHFA’s actions here or, more generally, endorses FHFA’s stunningly broad view of its own power. Plaintiffs – not all innocent and ill-informed investors, to be sure – are betting the rule of law will prevail. In this country, everyone is entitled to win that bet.

Brown added that even the main inspiration for delegating absolute authority to the FHFA, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), never granted such preemptive authority to its regulatory agency, Federal Deposit Insurance Corporation, when enacted during the savings & loan crisis.

Beyond Judge Brown’s dissent, a number of reputable sources months before had expressed the belief that Perry Capital shareholders had a compelling case. The Ninth Circuit Court of Appeals ruled in February 2016 in United States ex re. Adams v. Aurora Loan Services Inc. that the FHFA conservatorship does not negate the status of Fannie Mae/Freddie Mac as private firms for purpose of facilitation of False Claims Act complaints filed by the government. The conservatorship, said the court, does not “transform Fannie Mae and Freddie Mac into federal instrumentalities.” The court elaborated: “We agree that the FHFA has ‘all the rights, titles, powers and privileges of’ Fannie Mae and Freddie Mac. However, this places FHFA in the shoes of Fannie Mae and Freddie Mac, and gives the FHFA their rights and duties, not the other way around.”

That particular decision carried an implication in similar lawsuits against the sweep rule. For in holding that these corporations are private companies and not government agencies, the court effectively declared that the State of Delaware, where Fannie and Freddie are incorporated, has the final say. And the laws of Delaware do not authorize the sweep rule. Indeed, in July 2015, Myron Steele, the former Chief Justice for the Delaware Supreme Court, filed an amicus brief in the current case for the plaintiffs via the Alexandria, Va.-based Center for Individual Freedom stating just that. The rule, he argued, “is unenforceable and void ab initio under Section 151 of the Delaware General Corporation Law.” Steele emphasized: “The statutory invalidity of the Net Worth Sweep cannot be remedied retroactively by equitable doctrines.”

There are a number of outstanding shareholder suits against the Treasury Department and FHFA. Whatever their resolution, the whole experience underscores why even “successful” bailouts can be harmful. For once an enterprise accepts emergency government aid, it plays on government turf. And government can change the rules for any reason under the guise of serving a larger public interest. Fannie Mae, Freddie Mac and their shareholders didn’t anticipate the sweep rule back in 2008. But four years later the Treasury Department issued it, stonewalling attempts at discovery as to how it came about. Even assuming its necessity in 2012, the rule has outlived its use. Fannie Mae and Freddie Mac have repaid Treasury far more than what they owed. If the Trump administration really wants to “drain the swamp,” it should urge Congress to repeal both the sweep rule and the conservatorship authorizing it. It’s time to return Fannie Mae and Freddie Mac to the private market.