Fannie Mae and Freddie Mac formally are known as Government-Sponsored Enterprises, or GSEs. These days the “S” might stand for “stolen.” A group of their shareholders are arguing as much in federal court in Perry Capital v. Lew. The U.S. Treasury Department, claim the plaintiffs, overstepped its authority by impounding profits in perpetuity through its “sweep” rule of 2012. On Wednesday, February 5, the group, Shareholder Respect, held a conference in Washington, D.C. to highlight its view that the rule violates the terms of the temporary conservatorship under which Fannie Mae and Freddie Mac have been forced to operate since 2008. Ralph Nader, through his group, Public Citizen, organized the event. Speakers included the shareholders’ lawyer, former Solicitor General Theodore Olson. Anyone concerned over the future of property rights in this country should be following this case.
The Washington, D.C.-based Federal National Mortgage Association (“Fannie Mae”) and the McLean, Va.-based Federal Home Loan Mortgage Corporation (“Freddie Mac”) are secondary mortgage lenders. That is, instead of making loans to homebuyers, which is what banks, savings & loan associations and other primary lenders do, these companies buy existing loans from primary lenders and either hold them for investment purposes or eventually (as in most cases) package them into pools of marketable bonds, also known as mortgage-backed securities, to institutional investors. Fannie Mae and Freddie Mac’s charters from Congress, respectively, in 1968 and 1970, specify a mission: provide liquidity to promote homeownership. These corporations, in effect, are middlemen who connect mortgage and capital markets. In theory, it’s a win-win-win arrangement. Primary lenders can unload unproductive long-term loans languishing on their books and get cash in return; institutional and individual investors can derive a decent and safe yield on a reliable financial product; and homebuyers can realize somewhat lower interest rates. And the arrangement worked – for several decades.
The seeds of instability lay in these firms’ Government-Sponsored Enterprise status. Fannie Mae and Freddie Mac, by law, are required to expand homeownership opportunities across a wide range of the American population. Toward that end, they long enjoyed advantages over competitors, such as access to a line of credit from the U.S. Treasury and exemption from state and local taxes. While not formally backed by the federal government in the manner of U.S. Treasury bills or FDIC-insured bank accounts, these firms did constitute a government-sponsored duopoly in the service of a congressionally-chartered set of goals. For this reason, they were assumed to be “too big to fail.”
Protection from economic failure, unfortunately, also has meant exposure to political pressure and capture. Builders, bankers, community activist groups, financial brokerages, civil rights groups and other interest groups each have had a stake in boosting loan volumes and securitizing loans. This promotion of homeownership, insulated from ill consequences, led to the Great Mortgage Bubble of 2002-07. Back in 1980, Fannie Mae and Freddie Mac had bought a combined 7 percent of all newly-originated long-term residential mortgages. Within 30 years, this figure had soared to 70 percent. By that latter point, they held or guaranteed mortgages worth around $5 trillion. When house prices were rising, the problem could be camouflaged because the homes served as collateral. But when prices fell – and they fell hard starting in 2007 and even harder in 2008 – investors in Fannie Mae and Freddie Mac bonds, here and abroad, faced a wipeout. Neither company was sufficiently capitalized to handle the potential flood of claims.
Contrary to popular misconception, Fannie Mae and Freddie Mac were not at the leading edge of the mortgage boom. They got aboard after primary lenders dramatically stepped up their lending to borderline or unqualified borrowers. And when they did raise their high-risk activity, they had the good sense to avoid subprime loans. Yet the other part of the story was that it wasn’t just the prospect of business opportunities that brought these companies to the game. Congress, the Clinton and Bush administrations, and a host of community groups, starting about 20 years ago aggressively escalated the pressure on Fannie Mae and Freddie Mac to demonstrate their commitment to “affordable” housing. The Clinton administration, for example, required that Freddie Mac devote at least 21 percent of mortgage purchases be in “underserved areas” – that is, “low-income Census tracts or…low- or middle-income Census tracts with high minority populations.” The Bush administration, rather than eliminate or at least lower this quota, raised it to 39 percent. As a result of such mandates, Fannie Mae and Freddie Mac were forced to lower their standards of acceptable risk. In the process, banks and/or nonbank subsidiaries were encouraged to loosen their own standards. After all, these two companies were too big to fail. What harm as a result could occur to primary lenders?
As it turned out, plenty of harm occurred. The mortgage bubble burst during the second half of 2008, leaving Fannie Mae and Freddie Mac dangerously undercapitalized and their bondholders at the mercy of nonpaying homeowners. Institutional investors got slammed. Bear Stearns, which had invested heavily in mortgage bonds, already had collapsed earlier in the year. In response, Congress, under pressure from the Bush administration, passed the Housing and Economic Recovery Act (HERA) that July, which President Bush quickly signed into law. This emergency measure, among other things, created an independent entity, the Federal Housing Finance Agency (FHFA), to replace the existing Fannie Mae/Freddie Mac regulator, HUD’s Office of Federal Housing Enterprise Oversight (OFHEO). FHFA would be armed with far more authority than its predecessor. For one thing, it would establish tougher minimum capitalization requirements. For another, it would have the power to place Fannie Mae and Freddie Mac under conservatorship or, if necessity warranted, receivership. As a concession to community group networks, the new agency would be required to extract 0.42 percent of new Fannie Mae/Freddie Mac revenues and route the money to a National Housing Trust Fund. The legislation paved the way for a takeover. Financial titans Merrill Lynch and Lehman Brothers by now also were on the brink of collapse.
During the weekend of September 6-7, 2008, FHFA Director James Lockhart, with “encouragement” from Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson, seized Fannie Mae and Freddie Mac, and placed them under conservatorship. A temporary measure, conservatorship would force the GSEs to repay bondholders in a timely manner while still allowing the companies to continue to operate. The Treasury Department provided the companies with nearly $188 billion – $117 billion to Fannie Mae and $71 billion to Freddie Mac. But the GSEs had to pay a dear price for this apparent generosity. They agreed to forward dividends on senior preferred stock to the Treasury at the high rate of 10 percent. And they had to cede to Treasury warrants to purchase 79.9 percent of outstanding common stock at the price of $0.00001 per share. Talk about a bargain basement deal for the government!
The agreement, in other words, protected bondholders but left shareholders in the lurch. Indeed, the arrangement was much more severe than that the General Motors bailout, which at least allowed for resumption of normal operations if and when the federal government sold off its GM stake. Fannie Mae and Freddie Mae were on a very short leash. And it would get shorter still in 2012, ironically, with a markedly improved housing market. By then, the proportion of mortgaged homes whose debt exceeded market value (“underwater”), was peaking. House 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 increases in excess of 10 percent. The Federal Reserve System had embarked on a “quantitative easing” strategy to stimulate the economy, buying $85 billion worth of bonds a month (a program now being tapered). Of that sum, $45 billion would go for Treasury bonds and the other $40 billion would go for Fannie Mae/Freddie Mac mortgage-backed securities. And thanks to the unleashing of pent-up demand, the GSEs had become profitable again. “Housing is back,” Fortune magazine had declared the previous year.
The U.S. Treasury Department sensed as much. Recognizing an opportunity to accelerate its debt collection from Fannie Mae and Freddie Mac, the department on August 17, 2012 imposed a new rule known as the “sweep amendment,” or “Amendment Three,” that would supersede the 10 percent rule. The sweep rule, which went into effect last year, authorized the U.S. Treasury to seize all future quarterly profits from stock. Fannie Mae and Freddie Mac, though making good progress in paying their debts, now were little more than government agencies bearing a corporate logo. Company stock now was worthless.
A sizable number of shareholders, stunned, decided to fight back. Arguably the most important among them were holders of Fannie Mae/Freddie Mac mortgage bonds under the management of a New York-based hedge fund, Perry Capital LLC. On July 7, 2013, Perry Capital, acting on behalf of shareholders, filed suit against Treasury Secretary Jack Lew in the District of Columbia federal court alleging that the Sweep Rule was unauthorized. The suit also accused the Federal Housing Finance Agency of reneging on its conservatorship by not challenging the department. The plaintiffs hired Theodore Olson, Solicitor General during most of the first George W. Bush administration and now back at his old law firm of Gibson, Dunn & Crutcher, to represent them. The lawsuit seeks no monetary damages. It simply requests that the government abide by the authority granted to it by the 2008 HERA law.
The shareholders also have conducted a campaign in the court of public opinion via an ad hoc group, Shareholder Respect. And they have a key ally in their corner in attorney, consumer advocate and former presidential candidate Ralph Nader. At first glance, the partnership might seem like a poor fit. Nader for decades has been an acerbic critic of corporate conduct. Yet he is hardly a friend of the federal government. Moreover, he senses that Shareholder Respect, whose investors represent a wide range of household wealth and income, have a legitimate grievance. The Obama administration acted arbitrarily in forcibly liquidating Fannie Mae and Freddie Mac assets. If unchallenged, Nader argues, such action could be replicated against shareholders of any number of publicly-traded U.S. companies.
Federal officials, for their part, maintain that the shareholders have no legal standing. In filing a motion last December to dismiss the case, the Treasury Department argued that it hadn’t deprived investors of a return. The Sweep Rule, argued government lawyers, was instituted because of well-founded concerns that Fannie Mae and Freddie Mac might exhaust their federal aid prior to repaying their debt, which would have triggered an outright receivership. As the rule does not require any dividend payments to be made in the event the corporations lose money, this precautionary measure did not seek to deprive shareholders of income. In a response to the plaintiffs last month, government lawyers explained: “Treasury committed and provided hundreds of billions of dollars to rescue the entities. Having gained that benefit, the shareholders cannot credibly claim that the (Constitution) demands that Treasury compensate them further for their investment.” The government points out that Fannie Mae and Freddie Mac sent a combined $130 billion to the Treasury in 2013, a sum nearly seven times that which would have been sent had the Sweep Rule not been issued.
But this amounts to a specious rationale. It assumes that the government has the authority to use whatever method it deems fit to hasten the collection of a debt, even one repaid in a timely manner. Even private-sector bill collectors can’t browbeat debtors or garnish their wages on a whim; they have to adhere to the Fair Debt Collection Practices Act. Worse, it likely was the government’s intent well before the Sweep Rule to deprive shareholders of profits. In a memo dated December 20, 2010, then-Treasury Undersecretary for Domestic Finance Jeffrey Goldstein conveyed his view to then-Treasury Secretary Timothy Geithner that “the administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future.” Lawyers for the plaintiffs in the Perry case have produced this memo as evidence of a violation of federal securities law, which requires disclosure of material information to shareholders.
In effect, the Treasury Department, with the complicity of FHFA and other federal agencies, have operated under the assumption that shareholder rights are null and void simply because the companies in which they hold shares are under conservatorship. The government would seem to have a weak case. Yet even if the shareholders win, they face a long road ahead in getting back their investments. David Felt, former FHFA Deputy General Counsel for Conservatorships, recently remarked: “If investors are going to get any money out of this, it’s going to come out of the courts, and it’s going to take years.
Compensating shareholders, rich or otherwise, is the central issue, born of high principle. Nader hasn’t been mincing words these past several months. He had this to say in the following Shareholder Respect statement (“Fannie and Freddie Shareholders – The Forgotten, Used and Abused, Silenced Constituency”) issued last November 22:
The federal government – the Treasury, FHFA, and Congress – exploited and ignored the GSEs’ shareholders with zombie stock, and stuck them in financial limbo. The GSEs were required to pay above-market 10 percent dividends on Treasury’s investment, while many of the Wall Street banks that were bailed out with TARP money were required to pay dividends half of that rate. The shareholders of their bailed-out banks were preserved and given a chance to recover.
The FHFA ordered the Fannie and Freddie boards and executives to suspend communications with shareholders and abolish annual shareholder meetings. And finally, adding insult to injury, in 2010 the FHFA arbitrarily directed Fannie and Freddie to initiate and delisting of their common and preferred stock from the NYSE. This further degraded shareholder value and chased away many institutional investors.
In 2012, as Fannie Mae and Freddie Mac were returning to profitability despite financial and operating restrictions on their activities, the U.S. Treasury changed the terms of its investment in the GSEs to its own benefit. The Treasury replaced the already well-above-market 10 percent that the GSEs were paying to a “sweep” of all the profits of the companies.
This was the context of the conference held on Wednesday morning, February 5, at the Carnegie Institution for Science, located in downtown Washington, D.C. Shareholder Respect sought to dramatize its case, and more generally, the threat to property rights posed by the sweep rule. Leaders convened a panel of eight experts before an audience to discuss particular aspects of Perry Capital and other GSE shareholder cases (e.g., Fairholme Funds Inc., which, unlike Perry, is seeking damages), and how Fannie Mae and Freddie Mac shareholders can assert their rights. Current proposals in Congress – in the Senate by Bob Corker, R-Tenn., and Mark Warner, D-Va., (S.1217) and in the House by Jeb Hensarling, R-Tex. (H.R. 2767) – would abolish the two companies and replace them with a bank-influenced insurance-based system. Yet they fail to address shareholder grievances. The panelists, representing a wide spectrum of political views, were: Ralph Nader; Theodore Olson; James Glassman, fellow, American Enterprise Institute (and panel moderator); John Taylor, president, National Community Reinvestment Coalition; Ed Mierzwinski, consumer program director, U.S. PIRG; Sheila Crowley, president, National Low Income Housing Coalition; investor Tim Pagliara; and David Berenbaum, chief program officer, National Community Reinvestment Coalition.
The keynote speaker was former Solicitor General Theodore Olson, representing the plaintiffs. He had been sharply critical of the Treasury Department’s actions in a guest piece for the Wall Street Journal last July. And he did not disappoint at this event. After briefly summarizing the case, Olson declared: “It is the official position of the government to deprive shareholders of all gains.” He then gave three reasons why the Sweep Rule is illegal. First, the 2008 legislation that created FHFA requires that agency to conserve assets, not to keep them. Second, the Treasury Department violated its own terms by changing the rules after the 2009 deadline had passed. And third, the rule precludes all private ownership of Fannie Mae and Freddie Mac, effectively nationalizing assets. Put simply, Olson said, this is a case of legalized theft, one that sets a dangerous precedent for business everywhere in this country.
Other panelists made their criticisms known. James Glassman focused on the effect of the Treasury Department action on the rule of law. The sweep rule, he said, has laid the groundwork for mistrust of the law and of the safety of investments. People won’t buy property or otherwise invest unless they are certain that the rules won’t be arbitrarily changed to their detriment. This, he added, is the very purpose of the Takings Clause. Tim Pagliara, chairman and CEO of the Nashville-based CapWealth Advisors LLC, echoed this view, noting: “If they can do a net worth sweep of Fannie Mae and Freddie Mac, they can do a net worth sweep of anything in this room.” He added that he probably is the only person to have spoken with Senator Corker (R-Tenn.) on the issue of theft from shareholders. “The Corker-Warner legislation is counterproductive,” he said. “It would keep people uninformed and would result in costlier mortgages, especially when Basel III banking rules take effect.”
The other speakers, all on the Left, were less persuasive. They chose to focus on the necessity of maintaining, if not expanding, mandatory affordable housing goals for Fannie Mae/Freddie Mac. Apparently, they cannot grasp that applying the affirmative action principle to the mortgage industry, in ways direct and indirect, helped bring about the GSEs’ imminent collapse back in 2008. Still, one can be grateful for their support. Getting to choose allies is a luxury that only occasionally presents itself. Typically, circumstances dictate alignments. Politics – effective politics, at any rate – really does make for strange bedfellows.
As for the prime organizer of the show, Ralph Nader, about to turn 80, he remains a man of the Left. In other words, he’s not the sort of person with whom the National Legal and Policy Center often agrees. Yet he is an authentic populist, one of the few people out there capable of uniting strands of Right and Left discontent into a broad program. His forthcoming book, “Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State” (Current Affairs), discusses the possibilities for creating an effective counterweight to unchecked centralized power. It’s certainly worth a read.
The Perry case ought to be a focal point of this discontent. Evidence strongly suggests the Sweep Rule is illegal. While the regulation has accelerated repayment of Fannie Mae/Freddie Mac debt, it has done so by creating a license to steal. And with that debt now virtually retired, the main issue should be how to restore the autonomy of these companies and their shareholders – and without the guarantee of a federal lifeline. Conservatorship never was intended as a permanent arrangement. Yet that is what it has become. The Obama administration prefers it that way insofar as it enables the government to pay off its own debts. A shareholder win would be a clear victory for public accountability and property rights.