Q1. Please summarize the purpose of this Seeking Alpha article.
A1. There are numerous court cases in process that may affect the future prospects of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) (together known as government sponsored enterprises or GSEs) common and preferred stocks.
The focus of this article is the appeal of Judge Lamberth's decision (dated September 30, 2014) before a three-judge panel at the U.S. Court of Appeals, D.C. Circuit, which was a very adverse decision for GSE investors, e.g., FNMAS dropped from $9.20 on September 30, 2014, to $4.15 on October 1, 2014, a drop of about 55 percent. Three judges have been selected for this appeal. They are Judge Janice Rogers Brown (appointed by George W. Bush), Judge Daniel H. Ginsburg (appointed by Ronald Reagan) and Judge Patricia Anne Millett (appointed by Barack Obama). I do not discuss Judge Millett's economic views in this article.
Fannie Mae and Freddie Mac are private, investor-owned companies, but were placed in conservatorship on September 6, 2008. On August 17, 2012, the 3rd Amendment to the Senior Preferred Stock Purchase Agreements (SPSPAs) diverted essentially all of the GSEs' earnings to the U.S. Treasury (Treasury). The SPSPAs (including the 3rd Amendment) are an agreement between Treasury and the Federal Housing Finance Agency (FHFA or colloquially, "Fuhfa"). FHFA is the regulator and conservator of Treasury, but Director Watt has signaled his intent to defer to Treasury with respect to the SPSPAs, including the 3rd Amendment.
The GSE common and preferred stocks face significant litigation risk, but they also could have significant upside potential. Investors need to do their own due diligence of the risks and opportunities that the GSE common and preferred stocks may or may not present at the present time. There is at least the possibility of a favorable outcome someday. Indeed, an appeals court decision is likely, perhaps as early as the end of August, 2016 (the judges may prefer to have their current clerks available when they make their decisions. Clerks typically start their clerkships in September). Thus, the appeal could be a catalyst for price appreciation in the GSE common and preferred stocks.
Q2. As an economic expert, how would you recommend that the plaintiffs' attorneys rebut the 3rd Amendment in a way that is appealing to Judges Brown and Ginsburg?
A2. It may be plausible to conclude that both Judge Brown and Judge Ginsburg are activist conservative judges that are hostile to government interventions in the market; indeed, Judge Ginsburg is credited with coining the term "Constitution in Exile." However, care needs to be taken to explain the fact situation in such a way that emphasizes that Treasury/FHFA may have engaged in a politicized expropriation of GSE common and preferred holders just as the GSEs had begun to return to profitability. [Note: that Professor Richard Epstein, who has often written on the GSE expropriation and nationalization, is considered an "intellectual guru" of the Constitution in Exile movement.]
The GSEs are essentially New Deal institutions, but they have operated as investor-owned entities since the 1970s. This worked well for many decades. There would be periods of GSE financial stress (e.g., the S&L crisis period in the 1980s and the financial crisis of the 2008-2009 period), but in both cases the GSEs returned to financial health fairly quickly. Thus, the basic "public-private partnership" GSE model is not fatally flawed.
The Treasury did aid in the return to financial health by the GSEs in the 2010-2012 period. Treasury is entitled to a 10 percent dividend (12 percent if paid in kind) and has warrants to own 79.9 percent of GSE common stock. That is not disputed in this appeal.
The problem comes with the 3rd Amendment, where Treasury/FHFA decided to "hold up" common stock investors, depriving them from sharing in the benefits of the GSEs' return to financial health. Note that the contract negotiations between Treasury and FHFA do not have the appearance of an "arm's-length" bargain. It appears that Treasury may have been seeking to capture a windfall by expropriating GSE earnings going forward and that acting FHFA director DeMarco may have been eager for that to happen given his ideological opposition to the continued existence of the GSEs. I think Judge Brown needs to understand the 3rd Amendment in these terms.
What has happened via the 3rd Amendment is that investors in the GSEs have been directly expropriated as a result of actions by Treasury/FHFA that violate their fiduciary duties to treat "minority" investors fairly despite the fact that: (1) common equity investors are entitled to the residual after the GSEs' other financial obligations have been repaid; and (2) preferred stock is quasi-equity and the return to profitability circa 2012 would ordinarily have meant that GSE preferred stock dividends would have been restored years ago.
Judge Ginsburg is a University of Chicago (UofC) trained lawyer, was a student of Judge Posner at the UofC and thus is interested in the technical economic/legal "law and economics" academic literature. Thus, it may make sense to expand the economic discussion in law and economics terms, focusing on the rule of law and the hold-up problem within the context of the economics of contracts.
The rule of law requires that an executive branch department, such as Treasury and a regulatory agency, such as the FHFA, act in accordance with their legal authority. The 3rd Amendment has at least the appearance of being inconsistent with the Housing and Economic Recovery Act of 2008 (HERA of 2008) in that it violates the statutory goals of "preserve and conservative" and "safety and soundness." Note that I am not able to evaluate this issue fully as so much of the justification of the 3rd Amendment has been kept secret by Treasury/FHFA, although that may eventually change.
The hold-up problem emerges when firm-specific investments are made by transactors, i.e., GSE common and preferred holders investors and the government's senior preferred stock. What Treasury/FHFA did with the 3rd Amendment was to upend the traditional bargain between common, preferred, and new infusions of "senior preferred stock," so that Treasury could expropriate the quasi-rents. In this case, the "quasi rents" amount to essentially all of the GSEs' total comprehensive income, which, if not overturned by the courts, could persist for many years into the future.
Nobel prize winner in economics Oliver E. Williamson defines opportunism as "self-interest seeking with guile, to include calculated efforts to mislead, deceive, obfuscate, and otherwise confuse." It appears that the 3rd Amendment hold-up of GSE common and preferred investors was opportunistic in the sense that - despite their public statements to the contrary - the Treasury and FHFA may have known circa mid-2012 that the GSEs were soon returning to profitability.
While I do not have access to the discovery in the federal Court of Claims cases before Judge Sweeney, the plaintiff attorney in the appeals cases have supplemented the administrative records (or equivalent) in the appeals court cases. Thus, the judges in the Lamberth appeal will have the opportunity to judge for themselves whether the 3rd Amendment can fairly be considered a politicized hold-up of GSE common and preferred holders that amounts to the direct expropriation of these investors.
Q3. Please summarize the economic and financial issues that are before the appeals court.
A3. There are a number of economic and financial policy issues before the appeals court, including breaches of fiduciary duties, improper self-dealing transactions, and claims for damages. As I am not a lawyer, my focus is on the economic and financial issues that will be considered as part of the appeal. It is my understanding that the appeals court examines cases on a de novo (as new) basis.
In a previous article, I summarized the brief of the institutional plaintiffs (represented by Gibson Dunn and Cooper & Kirk) thus:
This brief can be summarized as follows: (1) the District Court ignored the fiduciary duty of the conservator to protect and rehabilitate entities under its care; (2) the net worth sweep exceeded FHFA's statutory authority as conservator; (3) the Housing and Economic Recovery Act of 2008 (HERA) does not prohibit claims that FHFA exceeded its statutory authority as conservator; (4) Treasury exceeded its statutory authority under HERA by acting after its authority expired; (5) Treasury's decision to execute the net worth sweep was arbitrary and capricious; (6) the District Court relied on incomplete administrative records; and (7) the District Court relied on facts outside of the complaint without affording appellants an opportunity to present evidence.
I summarized the brief of the class plaintiffs (represented by Boeis Schiller, et. al) as follows:
The brief argues, in essence, that: (1) the 3rd Amendment is an unfair self-dealing transaction; (2) HERA does not bar plaintiffs' fiduciary breach claims; (3) stockholders may bring derivative claims; (4) FHFA and Treasury owe a duty of loyalty to the GSEs and their other shareholders and the 3rd Amendment is inconsistent with this duty; (5) plaintiffs have valid claims for breach of their dividend rights, contractual rights to a liquidation preference, and contractual voting rights; and (6) plaintiffs have a valid claim for breach of the implied covenant of good faith and fair dealing.
Q4. Please summarize your understanding of Judge Janice Rogers Brown's views on economic issues.
A4. It is my understanding that Judge Brown has strong views on property rights and the role of government in intervening in competitive markets. In general, Judge Brown is very skeptical of the New Deal's interventions into the markets (i.e., "the revolution of 1937").
In a 2003 Federalist Society of Chicago speech, Judge Brown stated that:
Tom Bethell notes that the security of property - a security our Constitution sought to ensure - had to be devalued in order for collectivism to come of age. The founders viewed private property as "the guardian of every other right. … Protection of property was a major casualty of the Revolution of 1937.
In Hettinga v. U.S. (2012), Judge Brown's concurring opinion (which Chief Judge Sentelle joined) states that the milk regulation that was subject to court review
[R]eveals an ugly truth: America's cowboy capitalism was long ago disarmed by a democratic process increasingly dominated by powerful groups with economic interests antithetical to competitors and consumers.
Judge Brown's views hearken back to pre-New Deal views on the role of markets and investor-owned firms in the economy, with very limited government intervention into competitive markets judged to be acceptable.
Q5. What are the implications of Judge Brown's views on economic matters for the appellate court's review of Judge Lamberth's decision?
A5. One must start by saying that Judge Brown might consider Fannie Mae unfavorably as it is part of the "revolution of 1937." However, the question of the early history of Fannie Mae and Freddie Mac is not relevant to the consideration of the disputes that are before the appeals court.
Fannie Mae and Freddie Mac are investor-owned, for-profit companies that operate under a charter from Congress and the FHFA is both the regulator and the conservator. The dispute before the appeals court has to do with the 3rd Amendment to the SPSPAs, which is an August 17, 2012, agreement between Treasury and FHFA that amounts to the direct expropriation from GSE investors and the de facto nationalization of these companies.
The founders of this country, as Judge Brown noted above, viewed private property as "the guardian of every right." Thus, Alexander Hamilton, in the general introduction to the Federalist Papers, argued that the U.S. Constitution would provide: "additional security which its adoption will afford to the preservation of that species of [good] government, to liberty, and to property."
If the 3rd Amendment to the SPSPAs amounts to the direct expropriation of existing common and preferred investors via the "net worth sweep," which sends essentially all of the GSEs' earnings to the U.S. Treasury, this amounts to the de facto nationalization of the GSEs even though the statutory purposes of conservatorship of the GSEs are to: (1) "preserve and conserve" the assets of the GSEs; and (2) to ensure the financial "safety and soundness" of the GSEs.
One might plausibly think that Judge Brown may find that the actions of Treasury and the FHFA are inconsistent with the rule of law in the context of the property rights of GSE investors.
Q6. Do you have any comments on Judge Ginsburg's views on economic matters?
A6. Yes. I have performed a limited review of Judge Ginsburg's views on the role of economic analysis in the context of competition (antitrust) and intellectual property law.
In a 2010 article (with a co-author), Judge Ginsburg discusses how the "the predictability of economic analysis supports a rule of law regime," stating that
Predictability and certainty are surely virtues in a rule of law regime. The account we have given of the contribution that economic analysis has made to advancing those values should not be underestimated. Embracing economic evidence allows decision makers to apply a coherent system to each case and also enables private parties better to predict outcomes and thus to avoid litigation.
While the specific context of the GSE appeals court case has to do with direct expropriation and de facto nationalization, not the ordinary content of antitrust litigation, Judge Ginsburg's point is applicable here - if the courts were to allow this expropriation and nationalization of the GSEs the implication for other U.S. firms would be dramatic.
Judge Ginsburg has also written about the problem of "holdup" in the context of intellectual property litigation. Judge Ginsburg (with a co-author) points out that:
The original economic literature upon which the patent holdup theories are based was focused upon the various ways that market actors use reputation, contracts, and other institutions to mitigate the inefficiencies associated with opportunism in the real property setting."
Judge Ginsburg cited an article by Benjamin Klein in support of this statement. [Benjamin Klein, "Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships", 34 ECON. INQUIRY 444, 449-50 (1996).] Klein, Crawford and Alchian, who first wrote about the hold-up problem, did not focus on why hold-ups occur. Rather, they wrote about the various means that transactors use to prevent a hold-up problem from occurring over the term of the contract, including vertical integration, formal contracts, regulation, statutory requirements and so on.
Q7. How does Judge Ginsburg's discussion of probability and certainty and the rule of law fit into the context of this appeal of Judge Lamberth's decision?
A7. Following the rule of law instead of the rule of man means that official decisions will not be arbitrary, that due process and administrative justice will prevail and that constitutional, judicial and/or legislative checks on the power of the executive branch will provide constraints against arbitrary action by the government.
When a regulator, such as the FHFA, implements public policy as set forth in statute, there is an assurance that the regulator's power will not be implemented in an arbitrary and unfair manner and that the rights of the regulated "public utility" and its customers will not be violated.
What makes the actions of Treasury/FHFA with respect to the 3rd Amendment is that the net worth sweep is fundamentally inconsistent with the requirements of HERA of 2008. Under HERA of 2008, as conservator, the FHFA has the authority to
[T]ake such action as may be-''(NYSE:I) necessary to put the regulated entity in a sound and solvent condition; and ''(ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.
The problem with the net worth sweep is that it goes in the exact wrong direction, i.e., it makes it impossible for the GSEs to return to a "safe and solvent" condition and fails to "preserve and conserve" the GSEs' assets and property. This is why the 3rd Amendment is inconsistent with a reasonable understanding of the rule of law.
Many U.S. firms were "bailed out" during the financial crisis. In most cases, investors in the "bailed out" firms were treated relatively fairly. At the time the conservatorship was announced in September 2008, the announced intent of Treasury/FHFA was to treat investors in the GSEs fairly. Thus, in 2008, the FHFA stated that
Q: What are the goals of this conservatorship? A: The purpose of appointing the Conservator is to preserve and conserve the Company's assets and property and to put the Company in a sound and solvent condition. The goals of the conservatorship are to help restore confidence in the Company, enhance its capacity to fulfill its mission, and mitigate the systemic risk that has contributed directly to the instability in the current market. There is no reason for concern regarding the ongoing operations of the Company. The Company's operation will not be impaired and business will continue without interruption."
However, the practical effect of the net worth sweep is precisely contrary to the FHFA's statement quoted immediately above.
It was only on August 17, 2012, long after the U.S. economy had recovered from the 2008 financial crisis, that the 3rd Amendment was announced, which effectively takes all of the GSEs' earnings and transfers them to Treasury.
There is no serious argument that Treasury is not entitled to earn a 10 percent dividend (12 percent if paid in kind) on draws on the Treasury to support the GSEs. This also includes the Treasury's right to exercise its warrants to own 79.9 percent of the GSEs' common stock. It is the net worth sweep that is the subject of the appeal before judges Brown, Ginsburg and Millett.
The difference between the rule of law and the rule of man is, as Aristotle points out, that "it is more proper that law should govern than any one of its citizens."
Here, the source of the problem, the 3rd Amendment, is an agreement between Treasury/FHFA that they claim is protected from oversight of the courts. To me, this is an example of the rule of man, not the rule of law.
Going back to Judge Ginsburg's point about predictability and certainty, if the 3rd Amendment were to remain undisturbed by the courts, the implications for other regulated U.S. companies would be severe. There could no longer be predictability and certainty with respect to the property rights of owners of other regulated firms in the U.S.
Q8. What is the hold-up problem?
A8. The hold-up problem is a situation in which one actor makes a relationship-specific investment and then another actor has an opportunity to expropriate part or all of the return on the investment. Relationship-specificity investments are generally ones that have a high degree of asset specificity, i.e., once the investment has been sunk, it is not easy to redeploy the asset to a different use. One thinks of an oil pipeline, which, if oil production is depleted, would have little value for anything other than transporting oil.
Political risk is the risk that political decisions, events or conditions will significantly affect the forward-looking profitability and cash flows of a firm. Political risk can lead to direct expropriation, which can be defined as
nationalizing or expropriating an investment of an investor ... except when done for a public purpose, on a nondiscriminatory basis, in accordance with due process of law, and on payment of compensation.
Direct expropriation means a mandatory legal transfer of the title to the property or its outright physical seizure. Normally, the expropriation benefits the State itself or a State-mandated third party. In cases of direct expropriation, there is an open, deliberate and unequivocal intent, as reflected in a formal law or decree or physical act, to deprive the owner of his or her property through the transfer of title or outright seizure.
Benjamin Klein, in discussing the Klein, Crawford and Alchian paper that initiated the economic literature on the hold-up problem, explains that that paper does not "explain the existence of hold-ups, but rather the institutions adopted by transactors to avoid hold-ups." Klein notes that Oliver E. Williamson provides a "much more explicit answer to the question of why hold-ups occur," the answer being opportunism.
Williamson defines opportunism as follows:
By opportunism, I mean self-interest seeking with guile. This includes but is scarcely limited to more blatant forms, such as lying, stealing and cheating. Opportunism more often involves subtle forms of deceit. ... More generally, opportunism refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, obfuscate, or otherwise confuse.
Q9. Is the 3rd Amendment's net income sweep an example of the hold-up problem?
A9. Yes. The net income sweep is an example of an agreement by the Treasury/FHFA to take all of the GSEs' future profits and gift them to Treasury. There was no transparency, no administrative due process, no respect for Delaware and Virginia corporate law and no recognition that doing so violates HERA of 2008.
And the decision does seem opportunistic. Because of the secrecy surrounding the Treasury/FHFA decision making in agreeing to the net income sweep it's hard to evaluate the net income sweep, but it may be the case that Treasury/FHFA knew or should have known that the GSEs were soon to return to profitability.
Q10. Do you have any concluding comments?
A10. Yes. Oral arguments on April 15, 2016, will present an important opportunity to inform the three judges about the fact situation that is before them. Framing the presentation of the legal arguments to emphasize Judge Brown's skepticism of government intervention in competitive markets and Judge Ginsburg's interest in the law and economics, rule of law and the hold-up problem may prove useful.
Disclosure: I am/we are long VARIOUS FREDDIE MAC AND FANNIE MAE PREFERRED STOCKS, INCLUDING FMCKJ AND FNMAS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am an economic consultant and the author of The A to Z of Public Utility Regulation (Vienna, VA: Fortnightly, 2015). See: http://www.fortnightly.com/ATOZ.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.