Don't Cry for the Shareholders of Fannie Mae and Freddie Mac

"There is no distinctly native American criminal class save Congress."

Mark Twain


Update 1: Yesterday in The New York Times, columnist Gretchen Morgenson confirmed that the US Treasury has no intention of returning the mounting profits of the federally chartered housing agencies, Fannie Mae and Freddie Mac, to shareholders. In her fine comment, “The Untouchable Profits of Fannie Mae and Freddie Mac,” she reveals that Treasury Secretary Tim Geithner approved a policy that ensures that the “existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future.”

A number of people have expressed shock and outrage at this shabby treatment of the common shareholders of Fannie and Freddie.  In a post on Twitter in response to a tweet from your humble blogger, former FDIC Chairman Sheila Bair noted: “No sympathy for GSE shareholders here, but this is punitive compared to how AIG, Citi shareholders were treated.”

And of course Chairman Bair is right.  The common shareholders of AIG and Citigroup were not wiped out when these organizations received government bailouts under the doctrine of “too big to fail.”  

Our friend Nom de Plumber, who formerly worked at the Fed of New York and now makes a living in the risk management world, is similarly outraged:  

“If Treasury was so uncertain of GSE future, as it just stated, why did it need to seize surreptitiously such unforeseeable earnings, especially with zero public policy governance and disclosure?  Either liquidate under receivership, or conserve for debt and equity claimants under conservatorship. Treasury did half and half, skimming the earnings but keeping the liabilities off the US balance sheet. It was a revenue grab, violating the Constitution…  The core issue is following the asset conservation and shareholder disclosure rules which you set for others to meet.   Because the GSE are public shareholder companies, their governance is not exempt from federal investor-protection laws.”

Morgenson notes that the public disclosure from Fannie does not mention the Treasury’s intention to retain the earnings of the GSEs for the benefit of the US taxpayer indefinitely.  Freddie, on the other hand, does disclose that Treasury “has indicated that it remains committed to protecting taxpayers and ensuring that our future positive earnings are returned to taxpayers as compensation for their investment.”

There are now a raft of lawsuits pending against the US Treasury, both by common shareholders and investors in the preferred securities of Fannie and Freddie.  All follow the logic of Nom de Plumber and Morgenson, who see the actions of the Treasury as somehow unfair.  The lawsuits seek restoration of earnings and damages.  But while you may be able to justly criticize the Treasury for hypocrisy and inconsistency when it comes to federal securities laws applicable to private corporations, I am not sure that such arguments can be successfully made against agencies of the federal government. 

First let’s consider why Secretary Geithner chose to support a policy of confiscation of the earnings of the GSEs.  First and foremost, Geithner wanted to cripple Fannie and Freddie financially in order to prevent them from being restored to their former status in Washington.  For those who have not read Morgenson’s 2011 book which she co-authored with my friend Josh Rosner, Reckless Endangerment, the GSEs were the tail that wagged the dog of official policy on housing in Washington for years.  

By putting in place the tough agreement whereby the US Treasury injected preferred capital into the GSEs and in return has the right to confiscate all earnings of Fannie and Freddie indefinitely, Geithner sought to cripple these institutions as a political matter.  I rather agree with his judgment, but wish that he had put the two GSEs into receivership during the crisis.  With the higher fees put in place under the conservatorship, Fannie and Freddie look really profitable, at least in a nominal sense.  But if those profits are adjusted for the risk the GSEs take on housing, there are no profits.

Geithner told Congress in 2011: “The Administration is committed to a system in which the private market – subject to strong oversight and strong consumer and investor protections – is the primary source of mortgage credit.”  But the reality is that the U.S. government is the only entity that is willing and able to truly underwrite the risk of the multi-trillion dollar housing market.  

As we saw during the housing boom of the 2000s, when for a brief couple of years private investors did support a large chunk of the mortgage finance market, as soon as the true risks were revealed the private capital ran for the door.  Even commercial banks are unwilling to support more than a tiny fraction of the housing sector’s overall risk with their own capital.

In his book The Death of Liberalism, R. Emmett Tyrrell notes that during the chaos following the 2008 subprime market collapse; “Some institutions went down in flames, and the government backed institutions, Fannie and Freddie, went hat in hand to the taxpayer.”  Chairman Bair is right when she notes that the shareholders of AIG and Citigroup were treated better than are the shareholders of Fannie and Freddie, at least insofar as their ability to benefit from the financial recovery of these firms. But the key point to take away from that comparison is that the GSEs are not private corporations chartered under state law.  

In the United States, the roots of the subprime crisis of 2008 and the political reaction thereto stretch back to the founding of the republic.  In a legal sense, the power of the federal government to regulate finance begins with the 1819 Supreme Court decision establishing supremacy of federal law over conflicting state law.  In McCulloch v. Maryland, the Supreme Court settled a dispute that arose when Maryland sought to tax The Second Bank of the United States, which that was seen as endangering Maryland’s state banks during the depression of 1818.  The landmark Supreme Court decision confirmed that the Government of the Union, though limited in its powers, is supreme within its sphere of action.  The Court said that federal laws, when made in pursuance of the Constitution, form the supreme law of the land.  

As a practical matter, the power of the US Treasury and ultimately Congress over the GSEs is absolute.  The terms imposed by Treasury in return for the bailout are harsh and perhaps even unfair in a narrow sense, but it is far from clear that private shareholders have any power to object or seek redress.  If, for example, Congress passed legislation tomorrow extinguishing the GSEs without any compensation to the private “shareholders” whatsoever, it is clear that there would be no legal basis for objecting to this action.

Likewise, if Treasury were to put the GSEs into receivership, the private stakes could be wiped out and Fannie and Freddie would emerge as they existed when first chartered by Congress.  In a moral sense this would be wrong, but in a legal sense there seems little basis for private citizens to object.  This whole thing gets even more complicated for the common when one considers the "preferred" shareholders that Hank Paulson announced were being wiped out by conservatorship (to prevent a repeat of the Bear bankruptcy threat that got them $10 per share from JPM).  By the Deep Rock decision (equitable subordination) the common is stuck until the preferred (to which the Gov. has largely succeeded as banks went broke) is repaid.

The second issue that is equally powerful is the question of risk.  The whole operational basis for the GSEs was their implicit guarantee from the U.S. government.  Neither of these entities ever had sufficient private capital to achieve the “AAA” credit standing that Fannie and Freddie commanded in the past and still command today.  At best, the private shareholders of the GSEs were free riding on the backs of the U.S. tax payer, collecting supranormal returns for taking little or no risk – or at least we thought.  

For years the common and preferred shareholders of Fannie and Freddie benefited from the pretense that these corporations were, in fact, private for profit entities.  But in the background, federal officials regularly assured their counterparts around the world that the debt issued by Fannie and Freddie had the full faith and credit of the United States.  When push came to shove during the subprime crisis, the implicit guarantee became explicit and the private shareholders of both GSEs paid a terrible price.  But they should not have been surprised.  Morgenson includes an important quote in her piece:

“People disagree about what should happen to the G.S.E.’s,” said Matthew D. McGill, a lawyer at Gibson, Dunn & Crutcher in Washington who represents Perry Capital. “But if the plan is to wind them down, Congress provided a means to do that in the 2008 law — it’s called receivership, and it provides a host of procedural protections to claimants. What the Treasury cannot do is abuse its conservatorship powers to nationalize the companies and then, when it deems convenient, wind them down without the protections enacted by Congress.”

Well, maybe.  The trouble here is that the Treasury is only accountable to Congress, not to the private shareholders seeking redress in the courts.  The GSEs are creatures of the federal government, not the states.  They were “privatized” in name only under the Administration of Lyndon Johnson, more as an effort at fiscal window dressing than as a serious attempt to separate them from the federal government in a financial, operational or risk perspective.  

While private investors in the GSEs may not like the way that they have been treated since the 2008 bailout, there seems little that they can do except waste money on a lot of litigation that seems unlikely to bring relief.  Federal judges do not like second guessing Congress or the Executive Branch when it comes to the exercise of basic Constitutional powers.  For decades, private investors benefitted from the pseudo privatization of the GSEs and reaped enormous returns for essentially doing nothing.  Now those shareholders who were too dumb to head for the door when the music stopped want to be made whole for their losses.  

When considering what is fair to private investors in this situation, the treatment of the investors in the Madoff fraud comes to mind.  The investors are given back their original investments, but none of the pretended gains because the money was never really invested in the first place.  Perhaps such a scheme would be appropriate here.  But the only thing you can really say to investors in a GSE is “caveat emptor.”  When you as a private individual undertake to do business with a sovereign entity governed by politicians, you have only yourself to blame when the U.S. government decides to break its own rules on disclosure and securities fraud.  

This is just another Washington fable which reminds us all of the words of Mark Twain: "History has tried hard to teach us that we can't have good government under politicians. Now, to go and stick one at the very head of the government couldn't be wise."


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