People Really Didn't Like Fannie Mae and Freddie Mac
"Can the government commit securities fraud?" 1 is one question that is raised by Gretchen Morgenson's column about Fannie Mae and Freddie Mac this weekend. Fannie and Freddie seem to be having a cultural moment, with their hedge fund defenders -- Perry Capital, Pershing Square and, I guess, Fairholme 2 -- being joined by otherwise non-hedge-fundy types like Ralph Nader and Gretchen Morgenson to demand justice for Fannie and Freddie's shareholders, because I guess if anyone needs justice it's Fannie and Freddie shareholders.
The facts are long and convoluted but here is a mildly opinionated summary:
- In September 2008, Fannie and Freddie were Bad, and the government agreed to lend them vast open-ended amounts of money in exchange for (1) a 10 percent annual interest on those loans and (2) an 80 percent equity stake in the companies. 3
- For much of the next few years, Fannie and Freddie struggled even to pay the annual interest, with the absurd result that Treasury kept lending them more money to pay the interest that was owed to Treasury.
- By mid-2012, though, things had changed, Fannie and Freddie were profitable, and it looked like there was some chance that they might one day have enough money to pay back their loans 4 and once again become freestanding companies run for the benefit of their shareholders.
- But instead the terms of the bailout were amended so that, instead of getting a 10 percent return on its preferred stock, Treasury would just get to keep all of Fannie and Freddie's profits forever.
- Shareholders were bummed and did a whole lot of suing.
That's the story. I've in the past been a little sneery about Fannie and Freddie's shareholders' efforts to sue their companies back from the government, but honestly that story is not unsympathetic, in a very path-dependent way. Like, if the story was:
- in September 2008, Fannie and Freddie were Bad, so the government nationalized them and gave their shareholders nothing except a kick in the pants on the way out,
then those shareholders would still have sued their brains out and I'd have no sympathy for them. Because Fannie and Freddie were Bad, and more than that they were relying on an unpriced implicit government guarantee of their liabilities that benefited shareholders for years. And if the price of that guarantee turned out, ex post, to be total expropriation of shareholders, well, rough justice.
But that's not the story. The story is the thing above, with its two stages: The initial bailout, with a negotiated 10 percent rate plus equity ownership, was not a complete nationalization of Fannie and Freddie. And it was not a nationalization for good reasons, and those reasons were mostly for Treasury's benefit.
The second stage, which kind of was a complete nationalization, but without calling it that, might have seemed like rough justice in 2008, but in 2012 it just seems rough. Why should the government take away all of the profits from a profitable company, and give it nothing in return?
There might be some good answers to that question, 6 but the leading answer really seems to be because the government hated Fannie's and Freddie's shareholders and wanted to punish them. That's the theory behind, for instance, this Perry Capital lawsuit, and it's the theory behind Morgenson's column.
That column takes us back to December 2010, after the initial bailouts but before the return to profitability. That month, a Treasury undersecretary wrote a memo (to Tim Geithner) laying out arguments for and against waiving some fees that went along with the the Fannie and Freddie bailout loans. His reasons to waive the fees are long and boring, at least 10 bullet points, depending how you count. His reasons to impose the fees take up only two bullet points:
- Makes clear the Administration's commitment to ensure existing common equity holders will not have access to any positive earnings from the GSEs in the future.
- Illustrates further commitment to recouping taxpayer support.
The government did not impose the fees. So ... I mean, I guess that means that Geithner rejected the arguments for imposing the fees? Including the first argument, the one about the Administration's commitment to ensure that shareholders never saw any money ever again?
I dunno, this sentence from a memo halfheartedly supporting a policy that the government rejected doesn't strike me as completely airtight evidence of the government's official position, but whatever. In the event, the government really did end up making sure that common equity holders never got any positive earnings, so I guess that was the position, whether or not it was adopted in December 2010. Anyway, Morgenson:
Securities laws require material information — that is, information that might affect an investor's view of a company — to be disclosed. That the government would deny a company's shareholders all its profits certainly seems material, but the existence of this policy cannot be found in the financial filings of Fannie Mae. Neither have the Treasury's discussions about the future of the two finance giants mentioned the administration's commitment to shut common stockholders out of future earnings.
So was the government committing securities fraud? Sure, why not. 7 For giggles, here's Fannie's stock price from December 20, 2010 -- the date of that secret memo -- until September 1, 2012, two weeks after the government publicly announced that it was taking all of Fannie's profits for itself:
That profit grab hurt the stock a little, but not that much. That, and the fact that it now trades at $3.40 a share, four times the 2011 high, suggests that the government's officially stated position is not, you know, overwhelmingly material to shareholders.
The securities fraud question is ... I guess sort of an interesting one? Here, let me phrase it this way: When does the federal government become obligated to disclose facts that would be material to shareholders of public companies? My Google-based legal research has not been fruitful, but I'm going to go ahead and guess that the answer is "never," and that the government doesn't have to make policy pronouncements based on what shareholders want to know. But I could be wrong. 8
All of the wrangling over Fannie and Freddie's past is, of course, mostly a symptom of the wrangling over their future. And the fact that so much wrangling is happening now suggests, at the margin, that their future is looking a bit brighter. My assumption has long been that the status quo is great for the government. Right now, Fannie and Freddie are completely controlled by the federal government, while keeping the technical trappings of private ownership (20.1 percent private shareholders, no explicit government guarantee) and thus staying off the Treasury's balance sheet. They can be used as a tool of housing policy (particularly, they can keep guaranteeing cheap mortgages) without being explicitly federalized.
Doing anything with Fannie and Freddie seems like an annoyance. Making mortgage insurance an explicit government program, or really privatizing Fannie and Freddie, or anything on the spectrum in between, would require a considerable expenditure of political capital, and might even require legislation. 9 The only way that anything will happen with Fannie and Freddie is if the status quo -- the lawsuits, the awkward discovery in the lawsuits, the pressure from columnists and Ralph Naders -- becomes an even bigger annoyance than doing something would be. I don't think we're there yet, but we do seem to be getting closer.
Oh, I mean the federal government. Municipal governments can totally commit securities fraud. (Er, "can" meaning they can be charged with it. Not that they're allowed to do it. They're not.)
Not a hedge fund, fine.
Two corrections to that. One, that "loan" is technically preferred stock, and the "interest" is a dividend, though that has little practical importance for our purposes. Two, the 79.9 percent equity stake was to avoid taking the GSEs onto the government balance sheet: A key goal of all GSE-related maneuverings is to make sure that the GSEs' government guaranteed debt is not, for accounting purposes, treated as government guaranteed debt. Speaking of securities fraud!
Normally one can not really "pay back" preferred stock, but Fannie and Freddie's preferred stock actually had an "Optional Pay Down of Liquidity Preference" feature, so they could have paid it off.
That is: Treasury, for its own institutional reasons, doesn't want to consolidate Fannie and Freddie onto its balance sheet, as it would have to do with 80+ percent equity ownership. Consolidation would mean taking Fannie and Freddie's $5.2 trillion of liabilities onto Treasury's balance sheet, and, you know, Treasury only has so much room to take on liabilities.
The leading answer comes from Treasury's motion to dismiss one of the lawsuits in the case, particularly section II.D, starting on page 49, with the hilariously unambitious title "The Third Amendment Was the Result of Reasoned Decision Making." Treasury's argument is that, at the time, everyone thought that Fannie and Freddie's profits would never be enough to support paying a 10 percent dividend in the long run, so amending the agreement to make the dividend "whatever profits you have" rather than "10 percent of what we've loaned you" would make Fannie and Freddie more stable.
This argument ... consists of words? Here is a March 2013 report from the Inspector General of the FHFA pointing out that "over the long run, the new system could result in larger net payments to Treasury." Here is some simple arithmetic (based on ProPublica's bailout numbers):
[imgviz image_id:ijFmUh88lotQ type:image]
So since the amendment, Fannie and Freddie have paid Treasury a total of $111 billion more under the new plan than they would have under the old one. But they couldn't have afforded the old one. Hmm!
Why would the government do this? Well here is sort of a loony-sounding theory:
Failing to disclose the administration's hard line on the companies' shareholders is disturbing for another reason. In bailing out Fannie and Freddie, the Treasury received warrants — optionlike securities that rise in value when the shares underlying them do. When investors, hoping for a housing recovery, flocked to the shares and pushed them higher, the value of the warrants increased. Fannie's common stock now trades at $3.06 a share.
Given Treasury's interest in a rising stock price, depriving common equity holders of future earnings was especially important for investors to know, Mr. Lowenfels said.
The theory seems to be that Treasury was withholding negative news in order to push up the market price of its warrants, so it could ... sell the warrants at inflated prices? Obviously it did not sell the warrants, and selling the warrants directly contradicts the whole never-reprivatize-Fannie-and-Freddie plan. I do not understand this fretting at all. Just because you own stock, or a stock-like thing, does not necessarily mean you have an "interest in a rising stock price." I mean, usually it does, but this is not a usual situation.
Also, it's not like the government was really encouraging Fannie and Freddie shareholders. Ralph Nader's view is that the worst thing the government did to shareholders -- "the cruelest and most unnecessary diktat of all," in his words -- was delisting Fannie and Freddie from the NYSE in June 2010, six months before this secret Treasury memo. As Nader points out, this "took the shares down to the range of 30 cents, chasing away many institutional holders." Which was the point: to make it clear that you should only own Fannie or Freddie stock if you're a gambler or a kook. The plan more or less worked, though ran into the problem that the gamblers include Perry Capital, and the kooks include Ralph Nader. But, anyway, in December 2010, Fannie and Freddie shareholders can't have been feeling much love from the government.
The big appeal of the Fairholme plan to re-privatize Fannie and Freddie is that it probably wouldn't require legislation day one, though it would require handing valuable assets to hedge funds on day one, and down the line it would probably require legislation.
(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)
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