By Richard A. Epstein
On Thursday, July 18, Texas Republican Congressman Jeb Hensarling will hold hearings on his "Protecting American Taxpayers & Homeowners Act." The PATH Act contains many forward looking proposals, on which I have no comment. But on this occasion, I want to focus on one key feature of the Act, which is only obliquely revealed by the statutory title. Mr. Hensarling shows great solicitude for American taxpayers and homeowners. But in a telling omission, he gives the back-of-the-hand treatment to the preferred and common shareholders of Fannie Mae and Freddie Mac, (commonly called Government Sponsored Entities or GSEs). In the interest of full disclosure, let me state for the record that I have advised several hedge funds on the merits of the PATH Act, and on the parallel bipartisan legislation that Tennessee Republican Senator Bob Corker called the Housing Finance Reform and Taxpayer Protection Act of 2013, both of which are designed to wind down the operations of Fannie and Freddie.
Liquidating Fannie and Freddie The source of my concern with Mr. Hensarling's proposed legislation involve sections 103 and 104 of the Act, which, according to its legislative summary provides for "Termination of Conservatorship," such that "Five years following the date of enactment mandates the appointment of the Federal Housing Finance Agency (FHFA) director to act as receiver for each Enterprise (i.e. Fannie Mae and Freddie Mac) and carry out receivership authority." Section 104 then provides for declining maximum amounts that GSEs shall be entitled to own over the five-year transitional period before these entities are liquidated.
In one sense, the demise of Fannie and Freddie should not be lamented, after the long and sorry history of massive government intervention in their internal affairs that created serious dislocations in the marketplace in 2008, including, most notably, the Congressional insistence in 2007 that Fannie and Freddie issue some $40 billion in subprime loans. As a result of these actions, both GSEs suffered major losses during the early part of 2008, not unlike those suffered by other private companies. The nature of these actions are outlined in a complaint attacking the various government actions filed in Washington Federal v. U.S. in June 2013.
Therein hangs the following tale, which leads to the Hensarling hearings. Although not widely known, both GSEs are as organized as corporations whose shares are privately owned and publicly traded. The independence of these corporations was effectively ended in July 2008 when Congress passed the Housing and Economic Recovery Act of 2008 (HERA), which forced both companies, while still solvent and flush with liquid assets that could be either sold or mortgaged, into a conservatorship that was overseen by an agent of the United States, FHFA. I have described much of the early operations of HERA in my Defining Ideas column Grand Theft Treasury. The title summarizes my deeply critical attitude toward this problem.
In September 2008, the FHFA, as conservator of these GSEs, entered into a deal with the United States Treasury to organize a bailout of these still solvent entities. First, FHFA issued to the Treasury a new 10 percent perpetual senior preferred stock for which Fannie and Freddie over time received in exchange about $187 billion in fresh capital. As part of the deal, the Treasury received warrants to purchase 79.9 percent of the common stock at a nominal price of $0.00001, effectively wiping out most of its value. The now junior preferred stock remained on the books but had sharply diminished value. Clearly, the net benefits from this initial bailout were set by the Treasury, which exercised its power to buy into these GSEs at prices highly favorable to itself. At no point did the former directors of either GSE have any say on the terms of the deal. Essentially, the United States was on both sides of the transaction in a clear breach of the standard rule that all self-dealing transactions must be scrutinized to determine whether the shareholders' conservator provide them with fair value.
The Dubious 2012 Amendments to the 2008 Agreement Fast forward now to August 2012, at the start of the housing market recovery. At this time, FHFA and the Treasury entered into their Third Amendment to the 2008 Agreement which provided that "all positive net income each quarter will be swept to the Treasury." It is important to understand the unprecedented magnitude of this Amendment. At the time, Fannie and Freddie had returned to profitability and were thus able to pay both the interest on the Treasury's senior preferred stock and return some of the $187 billion that the Treasury had contributed to the both GSEs. This Third Amendment in effect stripped all the cash out of these companies and gave it to the United States as a "dividend" on its investment, with no reduction in principal.
Any sensible person would instantly realize that the unilateral variation in terms was not done to aid the private shareholders of Fannie and Freddie, but was intended to transfer all their wealth to the government whose crude contractual "amendment" violates the first principle of contract law: A and B may never enter into a contract that binds C without C's consent. What is truly amazing is the spin that Mr. Hensarling puts on this so-called Amendment in a document described blandly as PATH Act Questions & Answers:
Some are arguing that Fannie and Freddie have begun paying a financial benefit to taxpayers. While it's true that both companies had positive net income for the last three quarters of 2012 and have made $65.2 billion in dividend payments, these statistics don't give a complete picture of their financial situation. It is important to note that under the GSEs' contact with the federal government, these dividend payments cannot be used to offset prior Treasury draw, so that regardless of how much is paid out in dividends, the GSEs still owe taxpayers $187 billion in bailout funds borrowed And since their contracts with the federal government state that all positive net income each quarter will be swept into the Treasury as a dividend payment, in their current state the GSEs will never be able to repay that debt to the taxpayers.His "complete picture" of the financial deal is replete with half truths. It would help if Mr. Hensarling noted that he was speaking of the August 2012 Third Amended Agreement, which was signed only by two government operatives, then acting director Edward J. DeMarco of FHFA and Timothy Geithner, then Treasury Secretary. "Their contracts" with the federal government are not "their" contracts. They are just "contracts" that the government has entered into itself. The simple point here is that neither government agency represented the GSEs's shareholders who assets were stripped bare by government actions. Of course, the companies cannot pay back the debt because the government has seized all the assets that would allow that result to happen.
The Four Lawsuits It is no surprise that this highhanded action has attracted four major lawsuits in recent weeks. In addition to the Washington Mutual case, plaintiffs filed suits in Fairholme Funds, Inc. v. FHFA, (with Charles Cooper as lead counsel), Perry v. Lew(with Ted Olson as lead counsel) and Cacciapelle v. U.S., (with David Boies as lead counsel), attacking these sweetheart agreements and administrative shortcuts.Taken as a unit, these four lawsuits highlight three fatal flaws of the corrupt government deal of August 2012.
The first involves the blatant breach of the FHFA's duty of loyalty to the GSE shareholders, for whose sole benefit this arrangement was imposed. No fiduciary, government or private, may engage in collusive self-dealing that results in a huge one-sided giveaway of all corporate assets. FHFA is not exempt from this bedrock rule. Second, the Treasury's major abuse involves its conscious disregard of the explicit protections for GSEs built into Section 1117 of HERA. For starters, that section gives the Treasury only "temporary authority to purchase obligations and securities" up to December 31, 2009. That authority certainly did not allow the Treasury to engineer its one-sided 2012 sweep, except on the absurd premise that the statutory authorization to "buy" before 2010 implicitly authorizes outright government expropriation of GSE assets after 2009.
To be sure, the Treasury's temporary authority instructs it to "protect the taxpayer," and so it should be. But the phrase must be read in context. This instruction is meant to prevent the GSEs from ripping off the U.S. with one-sided deals. By no stretch of the imagination does that phrase authorize the U.S., in the name of taxpayers, to rip off GSE shareholders. Explicitly, HERA's statutory mandate only invites the Treasury to determine such financial matters as the maturity and risk of these notes, with the eye to making deals that allow for "the orderly resumption of private market funding or capital market access." However, the Treasury has not uttered a single syllable to explain why it's necessary to wipe out GSE shareholders by sleight of hand when ample funds are available to repay, with interest, the full $187 billion advance to these GSEs. Its brief public comment to date has echoed the point that it advanced $187 billion to Fannie, as it were, to maintain the solvency of both GSEs and protect the broader economy. The Treasury's email said "We fully believe our actions have been lawful and appropriate," without of course referring to the details of the Third Amended agreement. The normal tradition of judicial deference to administrative decision only applies to cases where there was reasoned elaboration before the government. It does not attach to imperial actions that are taken without public notice or comment or reasoned explanations.
Third, by stripping the GSEs of their assets by these verbal machinations, the Treasury and FHFA have taken the property of the shareholders--the corporate assets--without paying a dime in constitutionally required compensation. Remember, both Fannie and Freddie were solvent at the time of the August 2008 takeover, notwithstanding their previous run of losses. If the United States is allowed by fiat to throw solvent firms into government receivership, the Treasury's tortured logic would routinely allow the government to force any profitable corporation into receivership, thereafter to force a one-sided renegotiation of contracts that offers it huge dividends on nonexistent investments.
This logic holds even on the dubious assumption that that the GSEs got fair value for their perpetual 10 percent preferred stock. If so, proper accounting procedure requires the Treasury to first credit distributions to its 10 percent interest on the unpaid balance, using the remainder to pay down principal. By rough calculations, about $50 billion of the money paid to the Treasury should have paid down the debt, which would then decline from about $187 billion to approximately $137 billion. In effect, the desired remedy only requires courts to take the unexceptional position that the government cannot escape all of its fiduciary, statutory and constitutional obligations by re-labeling a return of capital as a dividend.
Ominous Long Term Implications The availability of a simple account fix to government overreaching lays bare the inexcusable workings of the Treasury's one-sided deals. Ironically, Mr. Hensarling's conscious effort to undermine property rights works at cross-purposes with his larger, laudable objective of trying to rid housing markets of their past, massive irregularities in order to encourage more private investment. What private fund will invest in projects when their cash can be siphoned off by dubious contractual liberties and administrative shortcuts that make a mockery of the rule of law? Why force hedge fund investors to bear losses created by a government money grab that wipes out all of the shareholders' legitimate anticipated returns? Prompt action is needed to stop Mr. Hensarling before his populist express gives us a rerun of the Chrysler and General Motors political bankruptcies about which I have written elsewhere. But if courts don't invalidate the government's contractual gimmicks and administrative shortcuts, this is exactly what will happen.
Richard A. Epstein is a professor of law at NYU Law School, a Senior Fellow at the Hoover Institution, a Senior Lecturer at the University of Chicago and a visiting scholar with the Manhattan Institute's Center for Legal Policy. His forthcoming book is "The Classical Liberal Constitution," from Harvard University Press in 2013. He has consulted for several hedge funds not involved in the ongoing litigation on the issues discussed in this Op-Ed.