Last week’s headline financial story was full of good news for the body politic. The United States Treasury reported a handsome second-quarter profit of $118 billion, which could cut down the deficit and postpone any politically charged negotiations over raising the debt ceiling. Half of that surplus comes from a combination of revenue increases from a slowly improving economy and expenditure cuts introduced in early 2013. The second half consists of a $59 billion “dividend” from Treasury’s “investment” to bail out The Federal National Mortgage Association (Fannie Mae) and The Federal Home Loan Mortgage Corporation (Freddie Mac).
To call that money a “dividend” relies on a profound public misunderstanding of the complex transactions that generated this ill-begotten Treasury bonanza. These transactions are being challenged in four separate lawsuits, which were recently filed, that attack the propriety of virtually every government action during the turbulent past five years. (Full Disclosure: within the past several months, I been hired by several hedge funds to advise them privately on the legal issues surrounding these events.)
The oft-neglected back-story of the “Fannie and Freddie Dividend” casts these transactions in a much darker light. Quite simply, the behavior of the U.S. government over the past five years has been marred by grave legal violations of bedrock principles underlying corporate, administrative, and constitutional law. The Back-Story
Act One: Organizing the Bailout
Prior to August 2008, both Fannie Mae and Freddie Mac were privately owned, publicly traded, and consistently profitable corporations that had issued large amounts of common stock and multiple classes of preferred stock. But both Fannie and Freddie were in obvious distress during the run-up to the September 2008 financial market meltdown, which prompted Congress to pass the Housing and Economic Recovery Act of 2008 (HERA) in July of that year.
Sentiment: Strong Buy
These are all very good and valid points when dissecting the current structure of F&F. The pressure is obviously mounting for congress to do something and will have a lot of heat from court hearings representing investors. I cannot play out any scenario in my head that is A) even possible to diminish F&F to replace with something else, B) more beneficial to do said act rather than restructure and release, or C) legally plausible to compete if attempted. It just doesn't make any sense to me to completely do away with something that is structurally sound (minus the naivety and greed influenced by banks) and the backbone to a lot of stability within the economy... But I'm young and not as experienced in this matter, and my small position really doesn't have any say in the matter in the end.
That behemoth law authorized the Federal Housing Finance Administration (FHFA) to place the corporations into a temporary conservatorship to preserve and to manage their assets in ways that would help stabilize the housing market.
Pursuant to that authority, the FHFA became conservator of both companies in September 2008. It promptly made a deal with the Department of Treasury under which Treasury would advance $100 billion (extended in May 2009 to $200 billion) in exchange for $1 billion in shares of senior preferred stock, which had an original face value of $1 billion dollars. That preferred stock would be increased dollar-for-dollar by any sums that the Treasury invested into either corporation and it carried a 10 percent dividend. At the same time, the Treasury received warrants to purchase 79.9 percent of the common stock of each entity for a nominal price measured in tiny fractions of a penny.
Section 1117 of HERA gave Treasury broad discretion on the terms and conditions that attached to its preferred stock, but it also required Treasury to take into account a number of conditions that related to the soundness of the government’s security for its advances and to the “orderly resumption or private market funding or capital market access,” which would allow Fannie and Freddie to each maintain their status “as a private shareholder-owned company.” Shortly after the 2008 deal went into effect, the value of the common and preferred shares both plummeted.
Act Two: The Third Amended Agreement
I will pass by the many complications that occurred between September 2008 and August 2012 to focus on The Third Amendment to the original stock purchase agreement of August 17, 2012, signed by both Edward Demarco, Acting Director of FHFA, and then Treasury Secretary Timothy Geithner.
Sentiment: Strong Buy
Its key provision simply ordered what the Treasury trumpeted, in bold type, would be (as of January 1, 2013) “a full income sweep of All Future Fannie Mae and Freddie Mac Earnings to Benefit Taxpayers for Their Investment.” Treasury announced the sweep only after it became clear that both Fannie and Freddie were returning to profitability. The stock prices of both sets of shares plummeted. By the terms of the deal, nothing was left for either’s set of shareholders in the absence of political relief or a successful lawsuit.
The Flaws of the Government Position
The Conservator’s Conflict of Interest
The shareholders’ grievance is quite simple: the disappearance of their wealth. The purpose of a conservatorship is to preserve the assets for the benefit of the individuals whom it represents, which in this instance covers both classes of shareholders. Accordingly, the conservator represents the shareholders in their relationship with the government. Under standard corporate law principles, that conservator is bound, as his name suggests, by a strong fiduciary duty to protect its assets for the benefit of both its common and preferred shareholders.
In this case, however, the designation of the FHFA as the conservator created an impossible conflict of interest. The Boards of Directors of Fannie and Freddie were shut out of the deliberations that took place exclusively between branches of the federal government.
Given that exclusion, the terms of the financial deal between the corporations and Treasury must be examined to see that in discharging their mandate “to protect the taxpayers,” the two government parties did not run roughshod over the issues of the preferred and common shareholders.
Sentiment: Strong Buy