Out of the ashes, a phoenix shall rise. But, unlike that creature from Greek mythology, the resurrection of Fannie Mae ("Fannie" (OTCQB:FNMA)) and Freddie Mac ("Freddie" (OTCQB:FMCC)) was not due to a miracle. No, these two companies recovered through a combination of 1) an improving economy, 2) effective management decisions, and 3) prudential stewardship by their conservator, the Federal Housing Finance Agency (the "FHFA"). And now these firms are experiencing robust earnings, with Fannie and Freddie reporting pre-tax income of $8.1 billion and $4.5 billion, respectively, for the first quarter of 2013; and they are expected to remain profitable for the foreseeable future.
Yet the FHFA has not taken any steps to prepare Fannie and Freddie for release from their conservatorships and for their return to the shareholders, even though it has become obvious to most interested observers that these companies have regained tremendous financial health. In fact, the FHFA did just the opposite when in August 2012 it agreed to the 3rd amendment to the Senior Preferred Stock Purchase Agreements (the "Agreements"). Beginning January 1st of this year, the enterprises are required to pay dividends to the U.S. Treasury (the "Treasury") in an amount by which their net worth at the end of the immediately preceding fiscal quarter exceeds zero, less the applicable capital reserve amount. As a result, the two companies are essentially imprisoned in their conservatorships, since they are unable to build capital in order to regain their solvency classification status under the Housing and Economic Recovery Act of 2008 ("HERA") and thereby qualify for release 12 U.S.C. § 4614(a)(1)(A-B).
This action by the FHFA is in stark contravention to its mandate as conservator under HERA that empowered the agency to take any and all actions as may be "necessary to put [Fannie and Freddie] in a sound and solvent condition" 12 U.S.C. § 4617(b)(2D)(i)-(ii). Moreover, this act is a deliberate attempt by the FHFA, and possibly the Treasury, to avoid the covenant to the shareholders that states, "Upon the Director's determination that the Conservator's plan to restore [Fannie and Freddie] to a safe and solvent condition has been completed successfully, the Director will issue an order terminating the conservatorship[s]" (Pg.2). This situation is something I wrote about last month.
A Change in Narrative
Up until now, the narrative has focused on aspects based primarily on the premise that the fate of Fannie and Freddie rests in the hands of Congress and the president, and that they and they alone will decide the future, if any, for these two entities without regard for the common and preferred shareholders. This is a theme that has been advanced by many financial and non-financial journalists and pundits who simply repeat what they have been told by lawmakers and the Obama Administration. But there is an overarching principle that is conspicuously absent from the discussion -- the FHFA has a fiduciary responsibility as conservator to the shareholders of these companies. Through the enactment of HERA, a commitment was made to restore these companies, if economic conditions allowed, and return them to their owners. And although the two companies are federally chartered, they are publicly traded, for-profit enterprises tasked with, among other things, providing liquidity and stability for America's housing finance system. So, after having kept the two companies in conservatorship for almost five years, the federal government is left with three basic options for the disposition of Fannie and Freddie.
The first option is for government officials to direct the FHFA to comply with the original intent of the conservatorships and amend, retroactively, the Agreements with the Treasury to allow the companies to use funds in excess of the 10.0% annual dividend amount for the rebuilding of their capital structures and the repayment of their debt to the Treasury, effective January 1, 2013. Additionally, the two firms are to be released from their conservatorships and returned back to the shareholders when each company has achieved certain risk-based capital requirements, as provided by law 12 U.S.C. § 4611(a)(1).
Furthermore, Fannie and Freddie are to be relisted on the New York Stock Exchange, with any remaining amounts owing on the Treasury's aggregate liquidation preferences to be satisfied by exercising whatever portions of the warrants are necessary to retire the debts and unpaid interest (dividend). Also, through a prudent mix of debt and unused Treasury warrants, the two companies could hasten the process of full recapitalization beyond the basic regulatory requirements. Consider, too, that conservative estimates indicate that on a fully diluted basis, the initial values of the common shares for Fannie and Freddie could be approximately $37.00/share and $29.00/share, respectively. And finally, if Congress still wishes to reform the enterprises, the Congressional Research Service has provided several alternatives in their February 2013 report to Congress that are not contrary to the conservatorships, the taxpayers, or the tax-paying shareholders.
The second option is for Congress to seize, once and for all, these shareholder-owned enterprises for public purposes, purposes that would preclude current shareholders from participating in the liquidated assets or the new or reformed companies' profits. This option is messy, though, because it would force the government to properly compensate common and preferred shareholders under the Fifth Amendment to the U.S. Constitution for the taking of their companies; thus, requiring forensic accountants, and micro- and macro-economists to determine the fair value of each company's common and preferred shares using the fair value of the assets and liabilities. And it would probably lead to a multitude of lawsuits that would challenge those fair value estimates and, subsequently, impede the implementation of any housing finance reform.
The third and final option is for Congress and the president to continue to do nothing as both companies and their shareholders languish in a state of uncertainty, while the Treasury's coffers fill with improperly appropriated and highly questionable gains. This option, however, will produce only one, very swift result -- a shareholder derivative suit. A shareholder derivative suit is a legal action initiated by one or more shareholders on behalf of the company against a third party (e.g., management, directors). In this case, the third party would be the conservator (the FHFA), and the cause of action would be for breach of fiduciary duty. But, HERA legislation was crafted 1) to prohibit shareholders from bringing suit, and 2) to limit judicial review.
A Matter of Law
Fortunately, a careful review of the law and of recent court decisions involving the FHFA, Fannie, and Freddie reveals something different. HERA stipulates that the FHFA "shall, as conservator or receiver, and by operation of law, immediately succeed to . . . all rights, titles, powers, and privileges . . . of any stockholder" 12 U.S.C. § 4617(b)(2A). This means that the FHFA acts on behalf of the shareholders and, consequently, substitutes itself as the shareholder in all derivative actions against Fannie and Freddie. However, the D.C. Court of Appeals found in Kellmer v. Raines, 674 F.3d 848 (2012) that "the statutory language bars shareholder derivative actions . . . absent a manifest conflict of interest by the conservator." Thus, a conflict of interest does exist, since the proposed action is not against Fannie and Freddie, but against the firms' conservator, the FHFA. So, the onus is placed upon the shareholders to defend the two companies from the actions of their conservator.
Likewise, HERA severely limits judicial review, stating, "Except as provided in this section or at the request of the Director, no court may take any action to restrain or affect the exercise of powers or functions of the [FHFA] as a conservator or a receiver" 12 U.S.C. § 4617(f). Therefore, in County of Sonoma, et al. v. Federal Housing Finance Agency, Case No. 12-16986 (2013), the appellate court held that "the courts have no jurisdiction . . . if the [action taken by the FHFA] is a lawful exercise of [its] power as conservator of [Fannie Mae and Freddie Mac]."
But the FHFA's action to amend the Agreements in August of 2012 was not a lawful exercise of its power as conservator, since the amendment intentionally prevented the companies from rebuilding capital and achieving a sound and solvent condition. Additionally, the court found it essential to underscore the FHFA's mandate to Fannie and Freddie by saying that the "FHFA has the 'incidental power' to take 'any action authorized by this section, which the [FHFA] determines is in the best interests of [Fannie and Freddie] or the [FHFA]' 12 U.S.C. § 4617(b)(2J)(ii)." Clearly, keeping the firms undercapitalized is neither in the best interest of the companies nor the FHFA.
One Final Word
HERA makes clear the conservator's purpose of ". . . rehabilitating the affairs of [Fannie and Freddie]" 12 U.S.C. § 4617(2). Furthermore, the purpose of the conservatorships, according to the FHFA, is "to preserve and conserve each [company's] assets and property and restore the [companies] to a sound financial condition." The shareholders in these two companies relied on the promises made by the FHFA and, thus, willingly bore the risk that the economy would either not recover quickly enough or substantially enough to allow Fannie and Freddie to survive. Now that they have come back, the FHFA has lost its way and decided that those promises are inconsequential in principal, on moral grounds, or as a matter of law.
John Adams once wrote that we are "a government of laws, and not of men," meaning that no one person (or agency) makes the laws or decides the laws, and no person (or agency) is above the law. The shareholders (both common and preferred) in these companies have legal rights that cannot be ignored or circumvented for political conveniences or objectives. And although the FHFA is owed a debt of gratitude for their sterling leadership during the dark days of the Great Recession, they need to return these entities to their rightful owners -- us. And if they cannot see their way clear to doing it voluntarily, then a court of law is going to show them the way. So, in the words of President Franklin Delano Roosevelt: "[They] have asked for it, and they're going to get it."